Investing is all about risk and reward. When investors take more risk, they demand more reward. One such “risk premium” is the concept of illiquidity.
Liquid assets are easily converted to cash. Stocks are liquid. You can buy or sell them five days a week.
But real estate is not as liquid. It takes weeks, months, or even years to finalize real estate deals. Investors in those deals are taking a risk by “locking up” their money in a rigid investment for an indeterminate time period. That extra risk necessitates a larger reward. This is the so-called “illiquidity premium”—more reward compensates more risk.
It might surprise you, then, that liquid assets have a major downside, too. Millions of investors have lost billions of dollars from this issue. And if you’re not careful, it might nip you too.
What’s the problem with liquidity? The mere ability to buy or sell an asset tempts investors to do so at the worst possible times.
It’s why Charlie Munger says,
When Warren [Buffett] lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”
Charlie Munger
20 investments in a lifetime? Munger believes that forcing yourself into illiquidity leads to better long-term outcomes. That’s why Warren Buffett investment approach is:
I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.
Warren Buffett
Five years?! Buffett completely ignores the daily liquidity of the stock market. Long-term investors make decisions over years, even decades. They don’t worry about days or weeks. When asked how long Buffett prefers to hold a stock, he answers:
Our favorite holding period is forever.
Warren Buffett
And it’s why one of John Bogle’s most repeated quotes is:
While the interests of the business are served by the aphorism ‘Don’t just stand there. Do something!’ the interests of investors are served by an approach that is its diametrical opposite: ‘Don’t do something. Just stand there!’
John Bogle
Legendary investors sharing the same idea. Maybe we should follow their lead? Illiquidity does not bother Buffett or Munger or Bogle. In fact, they view liquidity as an unnecessary tease.
Most “normal” investors like you and I don’t understand that. Too many of us see the stock market as a volatile casino, where short-term timing (luck? skill?) can help us make a quick 5%. Rinse and repeat, you’re rich! But study after study shows short-term investors performing poorly compared to the simple market indices.
Look hard at that chart. Balance portfolios returned 6-7% per year from 2001 to 2020, turning $1M into $3.5M. But the average investor only saw 3% annual returns, turning $1M into $1.77M. That’s a huge difference. And it’s largely attributable to average investors making dumb, short-term decisions. Or as JP Morgan’s team wrote:
Why does this happen? Because most investors buy and sell too much without knowing what they are doing. They buy and sell at the wrong time, but think they are doing the smart thing.
It’s the liquidity!
Daily decisions to buy or sell hurt our long-term returns. Personally, I’ve made 3 or 4 investment decisions in the past decade. All of those decisions involved buying diversified assets in small increments, or dollar-cost averaging, and holding them for many decades. I was lucky to have read John Bogle and Burton Malkiel before going down the wrong rabbit hole.
This is the liquidity premium. It only rewards you if you recognize it and choose to ignore it.
Therein lies the rub. Can you ignore the short-term noise – the media headlines, the loudmouth at the office coffee machine, your suddenly rich neighbor who bought Tesla options – and hold your simple investments for the long term?
Easier said than done. But it’s the easiest money investors ignore. And there’s a big premium if you get it right.
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-Jesse
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