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.

The greatest threat to your future financial security

The greatest threat to your future financial security is the loss, over time, in the purchasing power of power currencies.  A dollar today buys less than 5% of what a dollar bought 100 years ago.

Study the fascinating history and theory of money and use this knowledge as a basis in formulating and guiding your investment philosophy.

Ways to Limit Opportunity Cost - Most Important is holding Part of your Portfolio in Cash

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.  

• Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. 

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.  Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.  Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

• Equity investments in ongoing businesses typically throw off only minimal cash through payment of dividends.  
• The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.  
• Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.

Another way to limit opportunity cost is through hedging. 

• A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. 
• If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities .

Value Investors are absolute-performance oriented and are willing to hold cash when no bargains are available

Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that be come more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative-performance orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market.  Since the goal is at least to match and optimally be at the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

• Cash is liquid and provides a modest , sometimes attractive nominal return, usually above the rate of inflation. 
• The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. 
• Finally, unlike any other holding, cash doe s not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Be willing to hold cash reserves when no bargains are available

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation.

The liquidity of cash affords flexibility, for it can quickly be channelled into other investment outlets with minimal transaction costs. 

Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines

Why Hold Cash?

Liquidity brings opportunities.

Do not rush to invest in stocks as soon as you have additional cash available for investing.  Be patient and wait for good investment opportunities.

Holding cash or cash equivalents is not just for safety; it can help you earn more on your investments by enabling you to take advantage of opportunities that arise with brief windows in which to strike.  

From this perspective, keeping some cash or investments in liquid, low-risk securities may prove to be a high-return proposition in the long run.  

In some cases, it might be helpful to invest in convertible preferred stocks or convertible bonds, as long as you stay with established firms the way Buffett does.

'All cash' versus '80% cash and 20%' stock portfolio

When the market turned downwards recently, some bloggers declared that they had cashed out and were 100% in cash.  Yes, the market did turn down further, but then it rebounded quickly and to a higher level.

"When the market goes down, people think it will continue to go down."

"After the stock market has gone up, people think that the probability of the market continuing to go up is high."

If we slashed our stock-market exposure every time we felt uneasy, we would buy high, sell low and garner disastrous investment results.

Also these short-term events that we react to need to take into consideration two desirable yet conflicting goals - one goal is to avoid being poor and the other goals is having a shot at being rich. Each goal is desirable. The question is, how do you allocate your portfolio between these two goals.

Is being 100% in cash at any time a sensible action? Experts are unlikely to suggest an all-cash (or all-bond) portfolio. After all, a mix of 80% cash (or bonds/ and 20% stocks will have comparable portfolio gyrations, but with a significantly higher expected return. At the other extreme, advisers probably won't recommend an all-stock portfolio. They will plunk at least some money in conservative investments (cash or bonds), to temper the stock portfolio's price swings and provide money in an emergency.