Liquidity and the Perfect Portfolio

Published Local Article

Published in Bradenton Herald: June 16, 2015

By GARDNER SHERRILL  |Investor’s Column

More...

June 16, 2015

Liquidity and the Perfect Portfolio

Potrait of Gardner Sherrill

As a general rule, those moving into retirement should have plenty of liquidity to ensure they are able to meet current and unanticipated expenses.

But how much liquidity is actually needed? The tradeoff for any investor in keeping every dollar liquid is that while you will have the security of knowing you have immediate access to your capital, you may be increasing risk and reducing your longer-term growth and income opportunities.

David Swensen, manager of the Yale Endowment, noted in his excellent book "Pioneering Portfolio Management": "Market participants willing to accept illiquidity achieve a significant edge in seeking high-risk adjusted returns. Because market players routinely overpay for liquidity, serious investors benefit by avoiding overpriced liquid securities and embracing less liquid alternatives."

We use the term, liquidity premium, to explain the cost of having immediate access to the value of an asset. All else being equal, an investor pays a premium to purchase investments that have higher liquidity to those that have less liquidity. As a corollary, in order to attract investors to illiquid assets, it is necessary to offer either higher returns or lower risk relative to liquid alternatives.

An allocation to more illiquid investments requires an understanding of the inherent risks and constraints underlying such strategies. By definition you are locking those funds up for some period of time and relying upon your ability to sustain periods of uncertainty. Many investors were hurt during the 2008 financial crisis because they either had too much allocated to such strategies and / or didn't fully respect their emotional fortitude to wait out a sustained recovery period.

The 2008 financial crisis further intensified investor bias toward liquid securities and has thus arguably increased the liquidity premium beyond historical standards thereby creating opportunity for those willing and able to invest with a longer time horizon.

One seemingly positive feature of a liquid investment is the ability to receive continuous pricing on that investment. But is that really a positive? Dalbar's annual study, "The Qualitative Analysis of Investor Behavior," supports a long history of investors doing the wrong thing at the wrong time. They routinely react to market volatility by buying high and selling low. Money managers that employ liquid strategies are often forced to sell positions at inopportune times to raise cash to meet investor redemptions.

There can be behavioral benefits to enforcing a longer-term investment horizon on investors through an allocation to illiquid investments. It is said that in Chinese the word for crisis uses the two symbols for danger and opportunity. With capital "locked up," those that employ more illiquid strategies are provided the patience and discipline to take advantage of market fluctuations and pursue the opportunities. As Baron Rothschild stated, "the time to buy is when there is blood in the streets."

Roger Ibbotson, a professor of finance at Yale and historian of capital markets, has written extensively on liquidity premiums. He states that "30 years of academic research supports the fact that you can make higher returns with the same risk by purchasing lower liquidity securities."

So how much illiquidity is prudent in a portfolio? One must consider both the benefits and costs of increasing portfolio illiquidity. Review the ingredients list from my prior perfect portfolio article and work with your adviser to recognize the tradeoffs in all of the criteria so as to make a balanced assessment. The answer has to be determined on a case-by-case basis in consultation with the client.

As part of the consultative process, it helps to discuss, at least qualitatively, one's views and life circumstances. One may examine potential sources of excess return available from increasing the level of illiquidity (while holding the risk constant). The question then is essentially framed as "is the additional return and / or risk reduction worth the increase in illiquidity, given my situation?" Will it help me more effectively pursue my goals?

The more time spent on the front end, the more likely you will find a solution that meets your unique needs and tastes. To learn more, read my article from Nov. 11, 2014 titled: The Perfect Investment Portfolio, online with this column at Bradenton.com.

Gardner Sherrill, CFP, MBA, is an independent financial advisor with Sherrill Wealth Management. To learn more visit sherrillwealth.com. The opinions expressed in this material are not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial a registered investment advisor. Member FINRA/SIPC.

Need some Personalized Advice?

Contact us and I will happily guide you in the right direction.

Gardner Sherrill

After 16 years as a High Net Worth Private Banker I opened my firm in 2011 to create an unbiased and client-centered wealth management firm. As an independent advisor I can now solely focus on helping clients define and pursue their unique goals. Read More

Click Here to Leave a Comment Below