Sort your liquidity profile out

When considering portfolio liquidity I am reminded of my driving instructor’s advice about the impending test: ‘it’s not difficult but it’s easy to get wrong’. Many of the potential pitfalls are out of your control – for example less than perfectly rational decisions by other market participants can have serious implications for your investments – but, fortunately, some factors are in your control. There are two simple rules I like to keep in mind when thinking about liquidity: firstly, avoid lobster pots and secondly give yourself a long enough time horizon.

Other market participants are an important consideration when making an investment. This is because, ultimately, every asset class has limited liquidity. Some markets are very liquid whereas others are less so. Unfortunately some asset classes are easy to get into but very difficult to get out of, characteristics shared with lobster pots. A crustacean caught in a trap will likely meet an unfortunate end and investors trapped in an investment may also find themselves similarly committed to the fate of an asset class they had hoped to be able to sell.

In most instances our investments are commingled with others. You can’t predict their decisions and if they demand their money back at the wrong time, you may be faced with the prospect of either being stuck with the investment as it is ‘gated’ to redemptions or forced to sell the asset at a poor price.

Often people’s desire to sell an asset class is a consequence of price movements and the fact that people experience ‘losses’ when prices go down. There are, however, differences between permanent losses, which by definition cannot be made back and paper losses – or mark to market losses – which are painful but the ‘loss’ can prove transitory. There is no difference if you have to sell an investment when it is underwater, however.

Mark to market losses are important because in order to understand what a portfolio is worth today, the most readily available source of information, and the most objective, is to look at prevailing prices in a well-functioning market. This is called marking the investment’s price to the price available in the market. While reasonable, most investors think market prices can, at times, move a long way away from what is reasonable or fair.

We know that prices can deviate from fair value therefore. We also know that even a broken clock is right twice a day. Hence, the answer is to give oneself enough time for prices to move from undervalued to fair. This means, particularly with volatile assets like equities, give yourself time to sell things. Time is a great gift for investors and represents the most effective way to reduce the impact of short term market noise.

Avoiding lobster pots and ensuring that investors have a sufficient time horizon to realise returns are very useful ways to ensure that investors have the right liquidity profile. This, ultimately, underlines the importance of excellent investment due diligence because gaining a full and fundamental understanding of the investment is the best way to avoid lobster pots. In terms of time horizon, the more volatile an asset class the more important it is to think about a phased entry and exit rather than having an inflexible future date in mind on which you have to liquidate regardless of market price.

Richard Stutley, CFA