April 2011 - Personal Planning

Liquidity has always been an important consideration for investors. Described as the ability to readily convert something into cash, this critical feature became extremely pronounced and important during the severe credit crisis that gripped global financial markets in late 2008 and early 2009. Many people had to sell assets during this period of time, especially those with highly leveraged and illiquid holdings that dropped dramatically in value. This in turn forced those same desperate sellers to unload anything else they owned, which in turn compounded the decline in price of many liquid investments. And yet, many other investors were not in the same dire situation and they did not need to sell at any price, and they were clearly well-served if they did not liquidate their holdings at what turned out to be the worst possible time. Ongoing worries about everything from geopolitical issues to natural disasters have kept investors jittery and liquidity a priority.

We at Sand Hill have always placed an emphasis on the importance of investment liquidity—primarily because it enables us to achieve our objective of regularly rebalancing portfolios—as we strive to provide the best possible risk-adjusted real returns over time. However, in return for the ability to quickly convert commitments to cash, we believe that investors should also recognize the importance of having clear plans about the realistic holding period of their presumably well-chosen and generally long-term investments; and they should have discipline to stick with those plans. Like so many things in life, moderation is usually key. Liquidity is certainly important, but too much trading can typically result in counter-productive and adverse outcomes—and this applies to ease of buying as much as selling.

Online trading and other similar resources have only exacerbated the potential liquidity problem, to the extent that too much liquidity can be called a problem. Again, the basic idea of full liquidity is attractive, but the overall ease of transacting business in the capital markets today—not to mention program trading—can often be a mixed blessing. Remember the flash crash? Taken to the extreme in the aggregate, and particularly with regards to selling, it can dramatically feed the kind of panic that every investor, by his or her own individual action, is hoping to avoid in the first place. Obviously, nobody can control the actions of the crowd, but ultimately each individual investor should recognize that behind every transaction is an underlying commitment of some kind that should be embraced. In other words, a stock certificate is not just a piece of paper to arbitrarily trade, but rather evidence of ownership in an operating company. For the true investor, rather than the speculator, the decision to “own” that piece of paper should only be made in conjunction with a decision to own the underlying company, and typically this commitment needs to be long-term. The same is true for bonds and other kinds of alternative investments that are fully liquid and publicly traded.

Ideally, investors in publicly-traded securities should think like owners, regardless of the ease of purchase or sale of that ownership. Warren Buffett has said that he would be fine if the stock exchange were only open for one day a year to transact business because it would not alter his decision-making process, and he has advocated that other investors should approach investing in the same way. The typical real estate investor, who cannot easily buy or sell commercial or residential property, operates in a similar fashion. Except for publicly-traded real estate investment trusts (REITs), most real estate is still directly held and only occasionally, if not rarely, appraised; and the assets themselves are not usually easily or quickly traded. Of course, there is clearly a trade off caused by illiquidity, and it can be argued that the prices of illiquid assets are not truly reflective of accurate values at any point in time because of the lack of transparency and participation in the bidding process. But this process also typically forces its few participants to focus more on the fundamentals of the property itself and less on the emotion of the trade of the moment. Lack of liquidity is also prevalent in private equity, venture capital and other kinds of longer-term investments—even though secondary markets usually exist—and the performance of these kinds of assets is not necessarily harmed by limited liquidity. Indeed, the lack of liquidity is typically attributed with their success. The point is not that any particular degree of liquidity is necessarily good or bad – indeed it is critical to successfully functioning capital markets. Rather, it is investor attitude and how liquidity is managed that really matters.