By John Lunt, President, Lunt Capital Management, Inc.
Liquidity. It is admired as one of the most valuable attributes of any financial asset. The ability to quickly turn an investment into cash provides flexibility to respond to needs and opportunities.
For an investment to be volatile in the short term, it must be liquid. Therefore, liquidity is a necessary condition for volatility. Volatility can be painful, and our desire to reduce or avoid pain can be the catalyst for costly behavioral mistakes associated with investing. This leads to a fundamental investment question: can you handle liquidity?
For some investors, the answer is a definitive “No!” For these investors, volatility is the ultimate form of risk. They may feel comfortable taking significant risks in private equity or private real estate, but they find the volatility associated with owning publicly traded companies much more emotionally taxing. Rather than a “mark to market” publicly traded portfolio (which is often liquid and volatile), an investor in private investments can remain mentally and emotionally attached to original or previous values, therefore avoiding the mental anguish that accompanies the idea their investments may have declined in value. I am certainly not against private investments – appropriate private investing can be a valuable component of an investment portfolio. However, the different relative values of illiquid versus liquid investments (and their respective actual volatility) are often irrational.
This absurdity was on full display in a report by the Government Pension Fund of Norway. Their 2022 annual report stated, “The fund’s investments in real estate returned -14.1 percent in 2022…Unlisted real estate investments returned 0.1%, and listed real estate investments -30.8%.” In summary, they were making the case that liquid real estate (listed) was down 30%, while broadly similar assets held privately (unlisted) had lost no value.
Would small business owners or homeowners feel differently about their private assets if there was a ticker with current prices on display as they walked through the doors of their homes or businesses? They may believe they could ignore the price volatility because they are committed to their home or business for the long term. What if they had this same commitment and this same patience with a carefully diversified, liquid investment portfolio?
Illiquidity does not allow the same behavioral mistakes that are possible with liquid investments. It may protect investors from themselves. Liquidity makes some investors feel that because they can act with a simple mouse click or phone call, they should act! They might believe that when volatility and uncertainty strike, they should sell everything or abandon a carefully constructed investment portfolio or strategy. Because these assets are liquid, they can always easily come back into the investment when it feels better. Typically, investing only feels better after a meaningful part of the market and economic rebound has already occurred.
Can you handle liquidity? Only if you possess the two investment superpowers of commitment and patience. It is a superpower to maintain commitment and patience to long-term, liquid investing, grounded in reasonable, long-term investment assumptions. Long-term, liquid investment returns will not be consistent, as building wealth in liquid investments requires patiently embracing inconsistent and sometimes lumpy streams of returns. Committed and patient investors likely have a high pain tolerance, and they do not need instant gratification or constant, positive reinforcement. They are adept at filtering out the noise of instantly priced liquid securities and constantly changing investment account values.
These are increasingly rare attributes in today’s society and investment landscape. These committed, patient, liquid investors are likely adept at tuning out the deafening noise that surrounds modern investing.
Importantly, this does not suggest commitment or patience will win on their own; a sound investment approach is required. Time will not rescue a flawed investment strategy. Also, patience is not synonymous with only a “buy and hold” investment strategy. Commitment and patience towards well-designed, adaptive investment strategies that rotate, hedge, or tilt can be valuable components of a diversified portfolio.
Warren Buffett famously said, “The stock market is a device to transfer money from the ‘impatient’ to the patient”.” While investment theory has typically pointed to an illiquidity premium, there actually might be a premium that goes to committed, patient investors who can handle liquidity.
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