The Importance of Liquidity in Managing an Investment Portfolio

Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one's mind.

• If an investor purchases a liquid stock such as IBM because he thinks that a new product will be successful or because he expects the next quarter's results to be strong, he can change his mind by selling the stock at any time before the anticipated event, probably with minor financial consequences. 
• An investor who buys a nontransferable limited partnership interest or stock in a nonpublic company, by contrast, is unable to change his mind at any price; he is effectively locked in. 
• When investors do not demand compensation for bearing illiquidity, they almost always come to regret it. 

Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. 

• Few investors require a completely liquid portfolio that could be turned rapidly into cash. 
• However, unexpected liquidity needs do occur. 
• Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. 
• Most portfolios should maintain a balance, opting for greater illiquidity when the market compensates investors well for bearing it. 

A mitigating factor in the trade-off between return and liquidity is duration. 

• While you must always be well paid to sacrifice liquidity, the required compensation depends on how long you will be illiquid. 
• Ten or twenty years of illiquidity is far riskier than one or two months; in effect, the short duration of an investment itself serves as a source of liquidity. 
• Investors making venture-capital investments, for example, must be exceptionally well compensated to offset the high probability of loss, the large proportion of the investment that is at risk (losses are often complete wipeouts), and the illiquidity experienced for the duration of the investment. 
• The cost of illiquidity is very high in such situations, rendering venture capitalists virtually unable to change their minds and making it difficult for them to cash in even when the businesses they invested in are successful. 

Liquidity can be illusory.

• As Louis Lowenstein has stated, "In the stock market, there is liquidity for the individual but not for the whole community. 
• ''''The distributable profits of a company are the only rewards for the community."! 
• In other words, while anyone investor can achieve liquidity by selling to another investor, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate-share repurchases. 
• Except for such extraordinary transactions, there must be a buyer for every seller of a security. 

In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. 

• During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. 
• Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue. 

When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. 

• The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. 
• The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine. 

Investing is in some ways an endless process of managing liquidity. 

• Typically an investor begins with liquidity, that is, with cash that he or she is looking to put to work. 
• This initial liquidity is converted into less liquid investments in order to earn an incremental return. 
• As investments come to fruition, liquidity is restored. Then the process begins anew. 

This portfolio liquidity cycle serves two important purposes. 

• First, portfolio cash flow - the cash flowing into a portfolio - can reduce an investor's opportunity costs. 
• Second, the periodic liquidation of parts of a portfolio has a cathartic effect. 
• For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. 
• "Dead wood" can accumulate and be neglected while losses build. 
• By contrast, when the securities in a portfolio frequently tum into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.