Iron triangle of investing

The Iron Triangle of Investing: Choose Two…

Good/Fast/Cheap Model of Investing

There is a concept in project management called the Iron Triangle, or the triple constraint. Choose two: Good/Fast/Cheap. You can’t have all three.

When investing, similarly, you can’t have it all. Chose two: Safety/Liquidity/Returns.

Safety and Returns sounds a lot like Risk and Reward. As investors, we know all about that. But what about liquidity?

Specifically, the liquidity premium is a neglected topic. Well, actually, it is the illiquidity premium, and we will explore below why investors neglect it.

But first: the Iron Triangle of Investing.

The Iron Triangle of Investing

Choose two investing

Above, you can see the iron triangle of investing. You have to pick two of the three. Which will it be: Good and Fast (and expensive), Good and Cheap (and slow), of Fast and Cheap (and crappy)? This is the triple constraint: choose two.

What does that have to do with investing? While the iron triangle is developed to model the quality constraints during project management, it relates to investing quite nicely.

Quality in investing means getting the results you expect (meeting your goals), while maintaining flexibility. To translate:

  • Good: the equivalent in the investment world is SAFETY.
  • Fast: LIQUIDITY fits this nicely.
  • Finally, there is Cheap: Let’s consider this good expected future RETURNS.

So, another way to say good/fast/cheap is safe/liquid/profitable.

Perhaps there is not perfect homology here, but let’s do the same two of three combination.

  • Safe and Liquid (with poor Returns)
  • Safe and Profitable (with poor Liquidity)
  • Liquid and Profitable (and Risky!)
  • Choose Two

SAFETY, LIQUIDITY, RETURNS: Choose Two

good cheap fast investing

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

  • Good: Safety
  • Fast: Liquidity
  • Cheap: Returns

Let’s talk about examples of each.

Safety & Liquidity

Safe and liquid is pretty easy. That is 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. You can access it any time and you will not loose principle. The downside of good and fast: it is often expensive. That is, you get poor future expected returns. It is expensive because you earn poor returns on your money!

Safety & Returns

What is Safe with good returns? 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. Examples here: well, let’s explore this in detail below.

Liquidity & Returns

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

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: given the triple constraint, if you are going for liquidity and returns (via the stock market), you ARE giving something else up. Safety.

Are Stocks Really Liquid?

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. This is the cardinal sin of investing; selling equities when they are down. 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?

I contend that 100% liquidity (that AUM-advisors preach) is merely a mirage. It is not real. If you were 100% liquid all the time, then you wouldn’t get the equity premium. Only if you don’t HAVE TO sell are stocks worth investing in… when you can ride out the volatility.

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 really 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?

Liquidity Premium, or Illiquidity Premium

Let’s talk about the illiquidity 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 and illiquidity tie into return?

Investment Returns Increase with Illiquidity

investment returns increase with illiquidity

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 illiquidity premium? I’m going to let you figure that one out. What do you think has the longer holding period?

What is the 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?

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 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- The Iron Triangle of Investing

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.

But in one corner 100% liquidity is a mirage from an AUM Salesperson, and in the other, a source of mal-aligned incentives from the Insurance Salesperson.

While AUM-based advisors say you are fully liquid, are you really during a down market or if the funds are earmarked for another future goal? And while the insurance advisor says you can have all three, watch out for incentives, because often illiquid investment pays the most in commissions.

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 a return premium from illiquidity, but only if the underlying investment is sound.

Remember the next time you consider a long-term investment, is it good, fast, or cheap?

Choose two.

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5 Comments

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

  2. Most people want sold returns but safety, especially when focused on dividend investing. The premium for higher returns is often more volatility. I have not really heard of the concept of illiquidity premiums but it makes sense. Treasuries are very liquid but returns are low. Junk bonds are more illiquid and have higher returns. Stocks though are different, some of the most liquid stocks are generating higher returns, i.e. mega cap tech stocks.

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