illiquidity risk premium

Illiquidity Risk Premium

Illiquidity Risk Premium

The Illiquidity Risk Premium is paid to those who allow others access to capital.

The goal: to earn outsized returns. While it is nice to have some liquid emergency funds, much of your money can (and perhaps should) be illiquid. Illiquid means tied up; unable to be immediately accessed, perhaps for years.

Wait, why do I want my money tied up for years?

Illiquidity earns a risk premium and is beneficial behaviorally. Not only are you not tempted to sell in a downturn, you may also match future liabilities with access to funds. And in fact if you know the purpose of your money, you might do well to seek some illiquid investments.

When investing, you can’t have it all. It is a trade-off between illiquidity, returns, and safety.

 

Illiquidity Risk Premium is a Trade-Off

Illiquidity risk premium implies a risk/reward trade-off. More specifically, you have to choose two out of the three when investing: liquid/profitable/safe.

Let’s look at the combinations.

  • Safe and Liquid (with poor Returns)
  • Safe and Profitable (and Illiquid)
  • Liquid and Profitable (and Risky!)

LIQUID, PROFITABLE, SAFE

illiquidity risk premium

Above, you can see the implications when you have to choose two.

  • Fast: Liquid
  • Cheap: Returns (Profitable)
  • Good: Safe

Let’s talk about examples of each.

Safe & Liquid

Safe and liquid is pretty easy; you see above it is more expensive (it has poor returns). Examples include your bank account, savings account, high yield savings account, and the like. Here, you can have access to your money at any time, and it is frequently insured by the government (safe). It will not loose principle. The downside of good and fast: it is expensive! That is, you get poor future expected returns because of the liquidity and safety.

This is a prime example of the liquidity premium. You “pay” in order to hold cash.

Safe & Profitable

What is Safe and Profitable? Well, above in our figure, it “will take time to deliver.” This means, in investing terms, it is illiquid. You don’t have access to the money, hence the liquidity premium. Examples are provided in detail below.

Liquid & Profitable

This is the true holy grail of investing. What has good returns and is liquid: equities!

Wait! But at what cost? Above, you see it is “not the best quality.” In investing equivalents, that means there must be risk. Yes, we know the equity premium is all about volatility risk. Volatility, or risk of your assets being worth less than what you paid for them (in the short term), is the price of entry to get the returns associated with equities.

What I want you to consider: if you are going for liquidity and returns (via the stock market), you ARE giving something else up. Safety. You must not sell low!

 

Liquidity Premium and Stocks

Are stocks really liquid? Well, yes, you can sell them anytime the market is open. But do you want to sell them anytime the market is open?

That is, if the market has tanked and your stocks are down, are they really liquid? Well, yes, you could sell them and lock in a loss. So, during a down market, stocks aren’t really liquid at all!

Next, what about your stocks invested for future purpose? Say they are there to pay for your long term care needs in 20-30 years. Are your stocks really liquid? Well, yes, you could sell them and use them for something else, but that defeats the point of planning! You plan to have that money available in 20-30 years. If you consider it liquid and you can sell it at any moment, is it really there to pay for future goals?

With equities, you have technical liquidity but not true liquidity. Technically, you can sell that stock anytime you want, even if it was supposed to pay for long-term care expenses in the future. But truly, that stock is liquid if you have adequate long-term care insurance.

100% liquidity is merely a mirage. It is not real. If you were 100% liquid all the time, then you wouldn’t get the equity premium.

On the flip side, you hear insurance agents talk about how liquid the cash value of your life insurance is… you can take a loan out on your money within days. Further, they argue it is Safe (part of the general investment account of the insurance company), has good returns (bond-like), AND liquid (you can take loans out any time). While that all may be true, there is a layer of complexity added on to insurance products that make them less than transparent. And complexity and lack of transparency are the hallmarks of illiquid investments. Frequently, anyway. Buyer beware. You might be stuck with something and never really figure out how it works.

So, stocks aren’t truly liquid, and insurance products are mired in muck.

What is an investor to do? Well, what is your allocation to illiquid investments? Do you actually need all that liquidity in your life? Would you like to participate in the illiquidity risk premium?

Illiquidity Risk Premium

Let’s talk about the illiquidity risk premium.

Do you actually need 100% liquidity all the time? But, if you cannot access your money easily, there should be a reward. That is, there is a premium due when someone can use your money for a longer period of time while you cannot access it.

With bonds, you loan your money to the government or a corporation in return for coupon payments and a promise to return your money at some point in the future. But you can sell your bonds on the secondary market. Usually at a slight costs. New issues are slightly less expensive than those on the secondary market. Remember, though, bonds are important because they give you the freedom not to sell stocks when they are down. The tradeoff of owning bonds is they are more liquid (relatively, at times) than your stocks!

What about other assets? Is liquidity associated with price and future expected returns? That is, what about assets that don’t have a secondary market?

Think about the difference between your home and a diamond. Both have a market, but neither can generally be sold rapidly. Your home has a secondary market, but it is illiquid as it takes a while to access cash from it (unless you have a HELOC or a reverse mortgage already set up). A diamond, on the other hand, has a secondary market as well, but there is a steep drop off for the emotional toll you paid when first purchasing it. So diamonds are neither liquid nor are they fungible.

How about other investments? How does a secondary market ties into the illiquidity risk premium?

Investment Returns Increase with Illiquidity

the illiquidity premium

Above, you can see a simplified version of a pretty classic paper on illiquidity.

Note you have compound annual returns compared to an estimate of liquidity.

A deposit is the most liquid (on the bottom left), but has lower returns than government bonds. On the top right, you have private equity investments, which are the most illiquid but have (had?) the best returns. Below that, you see timber, which is clearly an illiquid investment as you need decades for the trees to grow.

Note, below the blue line (which represents poor liquidity/return premium), is real estate, and non-traded REITs. Above the line (good liquidity/return premium), find small equity (the small cap factor) and hedge funds.

I’m not suggesting you invest in hedge funds or private equity deals, as these may have had their time in the sun already. “Come for the complexity, and stay for the high costs!” But the idea is that these investments take 5 or more years to start paying off, so they should have higher returns because your investment is illiquid.

Finally, let’s talk about small cap value vs large growth. Which has the greater liquidity premium? I’m going to let you figure that one out. What do you think has the longer holding period?

What is the Risk Premium for Illiquid Investments?

All else being equal, a rational investor would prefer to hold liquid investments over illiquid ones. But if you don’t need the liquidity (and you don’t need 100% liquidity, nor do you actually want it!), consider what other options you have available to you which might diversify you away from the S & P and US Treasuries. What is your allocation to illiquid investments?

Have you Thought About Investing in Wine?

If low rate has got you down, think about some bond-alternatives.

Just make sure that you actually don’t need the money during the investment timeline, and that it is transparent enough that you understand that you are going to get a good value throughout the entire investment. Transparency and complexity are frequently where illiquidity becomes a nightmare. You give your money to someone else and hope they can earn a return worth the trust you place in them. Of course, you won’t know for years if they deserve that trust, or what the returns actually are… so, many times, illiquid investments become more speculation and less investment.

Ultimately, there is a risk premium for illiquid investments. A simple example is your own home. You don’t see daily fluctuations in the price of your home, so you are never tempted to sell it after its value drops by 10 or 20%. You have to hold on to it for a while. Thus, for most, home ownership is a good deal, because it forces illiquidity in part of your portfolio, with decent future expected returns.

Summary- Illiquidity Risk Premium

Liquidity is nice, but you only need so much of it. After all, do you keep a pool out back in case you need a drink of water? Or a place to park your yacht?

Fundamentally, remember, you do need some liquidity.

When considering illiquid investments: incentives matter and due diligence is a must. After all, you are stuck with it for a while.

You can get the illiquidity risk premium, but only if the underlying investment is sound.

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5 Comments

  1. Never considered stocks as illiquid from perspective of volatility. Interesting.
    Another great article.

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