Another instalment in a series of articles detailing how to design a secure, income-producing portfolio.
In my series of articles so far, we have dispelled the idea that liquidity is always and everywhere good, and we have shown that most liquid portfolios are not truly diversified. We’ve shown that liquid securities are volatile, and therefore expensive, because they have an easily accessible sell button, even as many people fail to examine liquidity’s true value-to-cost ratio. Everything we’ve come across has pointed to the idea that shrewd investors should consider diversifying beyond liquid securities.
Why, after all, should any portfolio that has a medium or long-time horizon be so heavily tilted toward assets that are easily sold? Why should endowment portfolios, which can be viewed as having an infinite time horizon, be concentrated in assets that have daily liquidity? The answer is they shouldn’t – and a financial planning tool that can be found in every investment advisor’s office has been saying as much for years, although no one’s noticed.
A key assumption of Modern Portfolio Theory is that there is some efficient frontier – that is, the optimal allocation of different assets – that offers the sweet spot of risk and return. Every financial planning shop is equipped with a computer model containing data on historic returns for different asset classes. To any given client’s specifications, the model spits out an optimal asset allocation for highest return with lowest volatility. But consider this: these computer models are almost always hard-wired to limit a portfolio’s illiquid hard assets, including real estate, to no more than 10% of total portfolio value. The fact that they’re hard-wired this way is a consequence of liquidity bias.
Meanwhile, in my years serving institutional clients, I noticed a curious pattern: every time I used one of those computer models for a client of any size, the allocation to hard assets went to exactly 10%. Not 9.5%. Not 6%. Not 7.7%. Always exactly 10%. This was the reason my colleagues and I eventually decided to run an experiment: We went into the back end of the model, and we removed that 10-percent constraint. We were curious to see what sort of results we’d get once the model could assign any proportion to illiquids. What would it do? 12% to hard assets? 15%? 20%?
We ran the model for the first client, and our jaws dropped. It said the optimal allocation to illiquids was a whopping 50% of the portfolio. In the months that followed, we ran this experiment over and over again for a range of different clients, and I saw that number go as high as 60%. 50%, it turned out, was about average.
In other words, all the data we have – including data that’s readily available at your broker’s office – suggest that virtually every portfolio should contain hard assets, and that the optimal allocation to hard assets is well over 10%. Meanwhile, most investors, from the largest to the smallest, hold well under 10% in illiquids. A lot of people are entirely in liquid securities.
Let’s return to a key lesson from one of my previous articles. What makes hard assets so different from stocks and bonds? A key distinction is that there’s no accessible sell button. Markets may fall, and you may feel very scared, but it will still take you months (or longer) to offload your interest in an apartment building. In that amount of time your fear will probably subside – plus you’ll be earning your monthly rental income, which will soothe your discomfort. And by the time you’d be able to sell that building, the markets have rebounded. You no longer want to sell, and you’ve avoided a potentially very costly mistake, of selling when markets were down. In essence, you win in this scenario because you’ve bought what you can’t sell, or what you can’t sell quickly.
The track record of one really famous investor drives this point home.
While fear and information overload are extraordinarily costly for most investors – because we panic and hit the sell button – a handful of investors have enjoyed long-term success because they don’t change their strategy regardless of what happens in the markets. The most famous of these is a guy named Warren Buffett.
The young Buffett picked insurance over all other industries because he knew it generated a lot of cash. Insurers get paid for a product that is just an agreement – an agreement to pay some amount in the future if a certain event ever occurs. Until that event occurs (or else forever, if the event never happens) the insurer holds the money. This allowed Buffett to accumulate immense cash holdings and invest. But as an investor, his behaviour wasn’t typical. He bought stuff. But he never sold.
While other investors get spooked and sell, Buffett almost never sells. In a sense, his vast portfolio is synthetically illiquid. He could hit the sell button any time. But he doesn’t, and as far as the rest of us mortals can tell, he never will. Long-term investors like Buffett don’t trade around a position or a market blip; instead, they let their position mature and produce a tremendous path over years, if not a decade or several. Buffett uses an approach of synthetic illiquidity to overcome the volatility that is so expensive for the rest of us.
Buy and hold works. If you have Buffett-like discipline, perhaps a portfolio wholly invested in liquid securities could be just as profitable as one that includes illiquids (though it would still be far more volatile).
For everyone else, there’s a nearly priceless lesson here – prudently buy what you can’t sell.
