Liquidity, of course, is simply the ease with which an asset can be converted to cash. It’s best defined as that thing that is always there when you don’t care about it and never there when you do.
Note that cash itself can be an illiquid asset, as you’ll discover if you buy a 30-day CD and suddenly need your money in fifteen days. Of if you go to your Greek bank to withdraw your euros and they give you New Drachmas. The cost of illiquidity in the CD case has a name: the penalty for early withdrawal. As does the New Drachma case: financial repression.
And then, of course, there’s liquidity and there’s liquidity-at-a-price. People who want to load up on stocks are always telling me that they’re a liquid asset – you can sell them any time that the market’s open, so what’s the problem? Well, sure you can sell them, but at what price?
People who owned tech stocks in mid-2000, or who owned any stocks in mid-2008, found out very quickly that, sure, they could sell those stocks, but only at a sacrificial price. Anybody who owns a significant fraction of the float in any security knows that if they try to sell their entire holding all at once, the price will be driven down.
The cost of illiquidity can also be measured in time, rather than dollars. The 30-day CD is a case in point. Or consider that you just bought $1 million of a 10-year, B-rated bond issue and the very next day the company was downgraded. You now have a mark-to-market loss, but if you can’t afford to realize that loss, all you have to do is wait ten years and you’ll likely be paid in full.
There are also securities that are inherently illiquid if they need to be sold quickly. Certain small bond issues, for example, are so thinly traded that it might take you several days – or longer – to dribble the sale out to the market. If you suddenly need full liquidity, you might find that you get no bids on the bonds at all.
Most of the time, the market rewards investors for bearing illiquidity. A 30-day CD will yield slightly more than a demand deposit. A small, thinly-traded bond issue will yield more than a similarly rated large issue. But it’s important to keep in mind that the premium embedded in the price of illiquid securities is based on the assumption that a typical buyer of the security can withstand the illiquidity as long as he is compensated for it. If you make the mistake of under-estimating your need for liquidity, you’re on your own.
We can examine the costs of illiquidity by comparing the outcome experienced by an investor who didn’t misjudge her need for liquidity with the outcome experienced by an investor who did. Alice owns a $1 million portfolio half invested in stocks and half in bonds. Her next door neighbor, Jack, owns a $1 million portfolio entirely invested in stocks. Both spend $50,000 a year from the portfolio.
If you suggest to Jack that his portfolio might be a bit on the risky side, he will chuckle and remind you that stocks are extremely liquid. He can sell any of his stocks – or all of them at once – any time the markets are open. And since his $1 million portfolio is minuscule compared to the trading volume in the markets, a sale by him won’t affect prices. He has full liquidity and there is no cost associated with it.
Along comes the Financial Crisis and bad things begin to happen. It turns out that a great many people under-estimated their need for liquidity, and they all flood the market with sell orders at the same time. The Dow plummets, prices gap down, trading is halted in certain shares that are getting especially pounded, and then trading is briefly halted in the entire market.
When the smoke clears, Jack’s portfolio has declined by 40%. In addition, he still needs his $50,000, so his total portfolio value is now $550,000. Jack is getting a bad case of the heebie jeebies, and his mental state isn’t improved when his financial advisors start pounding on him. They convene a come-to-Jesus meeting with Jack and point out that he is now withdrawing 9% of his portfolio every year, a wildly unsustainable rate.
But Jack takes a deep breath and hangs in there for another year. That year the market was flat, but Jack still needed his $50,000, so how he has $500,000 – half what he started with. He’s now spending 10% of the portfolio every year and at that point he bites the bullet and sells out. Not wishing to experience personal bankruptcy, Jack goes back to his possibly-sustainable withdrawal rate of 5%, except that he’s now getting only $25,000 a year. And since he’s now in cash, he misses the QE-powered rally in the stock markets. Things are not good around Jack’s household.
Meanwhile, chez Alice, matters are proceeding quite differently. When the market dropped 40%, Alice’s portfolio declined to $800,000. Alice needed her annual $50,000, but she didn’t get it by selling liquid-only-at-a-price stocks, she got it by selling truly liquid bonds. The following year, the market was flat and Alice spent another $50,000 from her bond fund, leaving her with $750,000. But then, courtesy of her friends at the Fed, QE kicked in and Alice’s stocks – she still owned all of them – doubled. She’s now back to where she started, with a $1 million portfolio. She is withdrawing 5% and getting her $50,000.
Next door, Jack can’t meet his mortgage payments and moves across town to a used double wide.
As this little chronicle suggests, liquidity can be ephemeral, and to say that investors are compensated for bearing illiquidity actually means something quite narrow: we are compensated for bearing illiquidity under normal market conditions.
With that in mind, we’ll turn in my next post to the current concern about illiquidity, which pertains to certain sectors of the bond markets.
Next up: Should We Worry about Liquidity? (Part 2)
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
