Originally published October 2021.
If there’s one thing you hear constantly in finance and investing, it’s stay liquid. That bit of advice is so common that most investors, from the smallest to the largest, tend not to question it. But what if it’s misleading or downright wrong?
Liquidity refers to how easily you can convert an investment into cash. A publicly listed stock like Proctor & Gamble can be sold at the push of a button – that’s quintessential liquidity. However, liquidating a real estate investment can take months, which means real estate is relatively illiquid. No one wants to be left holding an investment they can’t sell, so it seems to make good sense that everyone says stay liquid. And owning a portfolio of liquid securities like Proctor & Gamble is a great strategy if there’s someone who wants to buy what you want to sell and vice versa.
But what happens when there isn’t a buyer for every seller?
When something unsettling hits the news, a critical mass of people gets scared and some buyers become sellers and some long-term investors start thinking short-term. Prices drop and as prices go south it scares others who become uneasy as they watch the market change. They, too, become sellers. Many of these people weren’t consciously aware that they had a stop, a number below which they would feel so scared or so threatened in their financial wellbeing that they would decide to sell. They may not have a stop consciously in mind, but they have it nonetheless. Therefore, when the price gets too low for them to tolerate, they sell. The point is that everyone has a stop, regardless of whether they know it or not.
So, liquidity refers to the ease with which you can sell, thereby converting the investment to cash – but that’s not liquidity’s only defining feature. Another measure of liquidity is the extent to which any given investor affects the price by choosing to buy or sell. If, for a single market participant, the purchase of an asset increases its price or offloading it decreases the price, then that investment is not so liquid. Stock prices won’t change because today is the day you decide to tinker with your portfolio. During normal market activity, this makes liquidity cheap – that selling a liquid asset has only an imperceptible impact on its price. In fact, in a rising market, if you sell a stock that’s listed at $35.25, the price you receive may even be slightly higher because there is excess demand for that stock relative to supply.
“Liquidity means you can pretty much always get your money out, but you might not like the price”
However, when a critical mass of investors behaves the same way at the same time and they all decide to sell, it sends prices plummeting. When markets become turbulent, liquidity becomes expensive because your decision to sell now overlaps with many other market participants’ decisions to do the same thing. Then, your participation in a panic can affect the market as a whole. All it takes is one final actor who wants to sell one more share than buyers want to buy to precipitate a deep drop in price. Liquidity means you can pretty much always get your money out, but you might not like the price.
Meanwhile, as prices continue to drop, more people become scared, hit their own stop and also sell. This scenario is why you can look at every major low in the stock market and see the same pattern: a ‘V’. The V is the result of everyone having hit their stop; the bottom of the V is the point at which there are no more sellers.
But let’s play that scenario again from a different starting point. What if something scary hits the news, but you can’t simply press a button and sell? What happens then?
On 6 March 2009, the Dow hit 6,469.95, a decline of more than 50% since its high in October 2007. At that time, I was a managing director for a large investment house, where we were responsible for managing tens of billions of dollars on behalf of our clients. I managed real estate holdings, and as the Dow bottomed out and the whole financial world was in the throes of panic, what do you think happened to do those hard assets? They kept on generating cashflow in the form of rental income. In other words, they did exactly what they were supposed to do.
This wasn’t unique to the real estate holdings at my firm. For real estate assets across the US that were not over-levered – meaning the owners didn’t owe as much as the properties were worth – very little changed. Those properties kept generating income. Real estate, unlike stocks, is considered illiquid because it can’t be converted quickly to cash. So why did these illiquid assets perform so differently during the crisis as compared to their liquid counterparts, which had lost half their value and would take years to recover?
The answer to that question is both complex and simple, and I will go into more detail in my next article, but the simple answer is that while liquid securities tanked, illiquid assets that were not over-levered performed well because of their illiquidity – no matter how panicked their owners became, they could not easily sell those assets.
