By: Juan Carlos Herrera & Cole Conkling
Liquidity is defined as the ease at which an asset can be readily converted to cash. It’s one of the main benefits of investing in the publicly traded markets of stocks, bonds, and commodities. That you can readily sell such assets by the push of a button on your phone is an unbelievable accomplishment. This benefit, however, comes at a steep cost: having to see the market price of the assets every day. Us emotional humans are typically ill-equipped to handle these price swings, which can really be a problem for our long-term financial health.
Imagine you purchased a farm perfectly suited for growing corn and wheat on land you felt certain would steadily appreciate over time. Some years the crop yields are great, some years not so much. Or say you bought an investment property in a nice part of town. Some years the property would be leased out at high rates, other years maybe not. But again, you felt confident that, over time, the price of the property would appreciate. In both examples, you receive cash flows every year and have no plans of selling because you believe in the long-term prospects of your investment. You’re, therefore, not particularly worried about the short-term news of the day, nor are you concerned with what you could get if you sold your investment today—because, again, you’re not selling for many years. Over time, both the farm and the rental property appreciate substantially in value, and when you sell many years later you receive a substantial profit, all while earning cash flows each year. Here, you were a patient investor and it paid off
Now imagine you invested in shares of every publicly traded company in the world—over 9,000—companies like Apple, Google, Tesla, Toyota, Sony, Nestle, JP Morgan, and Tencent. Imagine you also invested in all the bonds (more than 19,000 bonds, issued by governments and companies), commodities (e.g., oil, gold, wheat, silver, etc.) in the world. Over time, the stocks, bonds, and commodities also appreciate substantially in value. This time, however, you don’t hold to sell many years later, but rather exit and enter these investments multiple times depending on whatever the market price is on your phone. Sometimes you buy or sell at the right moment, but mostly you don’t. Even though the investment ended up appreciating even greater than the private investment examples above, you don’t receive all the profits due to your poor market timing. In the end, you realize you would have been better of just holding on through thick and thin like you did with the private investment examples above. Here you were an impatient investor, and it hurt you.
So, why the difference? Why do we tend to be patient investors with private investments and impatient investors with public investments? Afterall, the risks are much higher in the private investment examples as there is less liquidity, less transparency, and much less diversification. Access to liquidity means there is someone offering to buy your investment, allowing you to always know the true value of it. However, that also means that the price will move constantly depending on new information being received by your potential buyers. This creates temptations for many investors to buy and sell quickly in hopes of quick profits, or to avoid temporary losses. It also creates heavy emotional swings each time an investor checks the value of their investments. The price of a private investment, on the other hand, is unknown because there’s no active market of buyers constantly “knocking on your door each day” making an offer to buy your farm or rental property.
With the private market examples, investors tend to focus more on the cash flows they receive from the farm’s crops or the leased property and pay little to no attention to the actual value of the asset itself. This is one of the main reasons investors believe that their private investments are less volatile and “safer” than public investments. But this is simply an illusion since the actual value of private investments are largely unknown. The true value of a private investment is only known when an bona fide offer to buy is received and, in most cases, this does not happen until the owner tries to sell it. Let’s break this down further.
If you want to sell your house right now, the actual cash value to you is zero. Yes, zero! That’s because you presumably don’t have a current offer to buy it and, therefore, it cannot be converted into cash today. Your house is, thus, an illiquid asset. Even with a ready cash buyer, it will take some time for the transaction to close and for you to receive your money in hand. But you might say that you have an appraisal of its value, or an idea of what you could sell it for based on comparable houses in the market. Appraisals and rough valuations, however, are not the same as bona fide offers to buy; nor are they the same as a closed transaction with cash in hand. What if the market changes from when the appraisal was done? What if a latent defect is discovered during the inspection process that drastically lowers the value of your home? What if interest rates shoot up, making your buyer pool smaller and less able to finance the purchase at your offered price? You might think your home is worth a certain amount, but if you’re in urgent need of the money today and nobody is there to make an offer and close today, then the price is zero until the deal is done. Business owners often make this mistake too by comparing the value of their investment portfolios with the paper valuations of their private, illiquid company or other private investments. That’s why there is a premium on liquid assets like public stocks, bonds, and commodities: They can be readily converted to cash today. Their true market value is known right this very moment.
The laws of risk and return apply to all investments, not just liquid, public investments. And the correlations between asset classes in the private and public markets are very high. If the economy is strong, both public and private assets will do well; if the economy is weak, both will suffer. You may not realize how much your private investments are suffering, because you cannot readily see the market price, but you’ll find out if you try to sell. Investors need to approach investing in public markets the same way they do private markets and view the liquidity in public markets as a benefit instead of letting the price swings sway them emotionally. Investors are better off ignoring all the news and noise regarding the public markets just like they do when evaluating how their private investments are doing.
Know what you’re buying!
Public markets can seem overly complicated, with numbers constantly whizzing by on T.V. screens all day and prices seemingly moving with all the grace of roller coaster. A lot of people get overwhelmed and go to private markets or deals that they can “touch and see,” “know,” or “understand.” This, however, may result in earning less on a private investment than they could have on a similar public investment. Or taking more risk for the same return they could have gotten in the public markets. Others might hire a professional adviser to help them with their public investments, without really understanding what’s going on—“I’ll let him deal with it” they might say. This blind, ignorant trust usually dissolves when markets crash, ending with phone calls to the adviser to “get out and get out now.” Indeed, one of the main reasons investors sell during temporary drawdowns is that they don’t understand the investment and fear it will never come back. This is understandable.
Let’s go back to the private investment examples again. Imagine you’re not ready to sell, but that someone offered to buy your investment for 15% less than what you thought it was worth. Would you sell it to them? If you don’t need the money and remain confident that the farm or rental property will appreciate over time, then probably not. The difference here is that the investor feels comfortable in understanding what a farm or property is and that it will appreciate over time. Maybe you think to yourself: That buyer is wrong, he doesn’t know what he’s talking about, he doesn’t understand this market or my investment, what a lunatic!
Public markets should be viewed the same. Most people get into trouble because they don’t really know what’s in their public investment portfolios and view price swings like a casino that randomly fluctuates. But just because you can buy and sell at any time doesn’t mean you should. As an investor, you must understand (and believe in) the assets you’re holding, while keeping in mind that the daily gyrations in price are akin to the hypothetical buyer offering to buy your farm or rental property for 15% less than what you paid for it. In both examples, you have the choice to ignore the offers or not.
What about fixed income investments that don’t have much volatility, like bank savings accounts or certificates of deposits?
Let’s assume you make an investment in a one-year T-Bill at the end of 2018 that paid you 2.63%. You know that after one year you’re guaranteed by the U.S. government to receive a 2.63% return. Let’s also assume that you have an investment in a passive diversified portfolio of global stocks and the value of that portfolio is temporarily down 10% from the moment you invested. Are you better off in the one-year T-Bill guaranteed to pay you 2.63%? Maybe, but that depends on what your investment goal is and how risk tolerant you are.
Now let’s see what happened 12 months later:
The low-risk T-Bill investment still looks better over this period, but now you must decide what to do with the money, since the 1-Year T-Bill paying 2.63% has matured. Do you buy another T-Bill or invest it in the stock market? Again, this decision depends on your goals, time horizon, and risk tolerance. Let’s assume you repeat the investment but now must settle for a lower yield of 1.73% for the next 12 months on the T-Bill. Your investment in the stock market remains since you never sold out of that. Let’s fast forward another 12 months:
Wow! A lot has happened. Covid-19 hit, and the world changed on a dime. But after these last 12 months, with all the ups and downs, your stock market investment is up 12% and you now must decide what to do again with the money that has returned to your checking account from your T-Bill investment. However, now the interest rate for the next 12 months is low and will only pay you 0.12%. Let’s assume you remain very risk averse with these funds and decide to repeat the investment for another year. You still don’t sell the stock market investment. Let’s fast forward a year:
Your stock market investment that started down 10% is now up more than 43% and once again your T-Bill money is back in your checking account after another 12-month period. Now let’s say you are not interested in the low rate of 0.09% and instead of re-investing your T-bill proceeds you decide to invest it all into the stock market investment. Afterall it’s done amazing! Let’s now fast forward to today.
As of March 24, 2022, this is where you stand:
Now what do you do?
The point of this exercise is that if you’re looking to earn more than the risk-free rate of return, you’ll have to tolerate some volatility. How much will again depend on your risk tolerance. Remember there’s no free lunch and trying to time the market in the long run is also not a good idea. If you want high expected returns, you’re going to have to take some risk. But volatility shouldn’t be a problem if you know what you are investing in and are patient like the private investment examples. If your global stock portfolio is down 25%, like in the examples above, remind yourself that you own the largest 9,000 companies in the world and if that doesn’t bounce back then nothing will. You shouldn’t mind the fluctuations of your investments in the short term if you are not planning to sell anytime soon. Remember that volatility is like the random person knocking on your door every day offering you crazy prices for your investments—ignore it!
Bringing it all together.
Let’s see a few more examples of public and private investments to further illustrate how investors should view them the same. Let’s first look at the price of an average home since the year 2000.
It looks like a smooth curve going up with almost no volatility, right? But that’s because it’s not a liquid asset and the measurement used to calculate this is an average of home price sales throughout the United States, not actual daily prices of bids and asks on home prices. But what would have happened if you had also invested in the S&P 500 during this same time?
If you can ignore the noise of the daily liquidity the stock market offers, your investment would have grown more than three times. However, while it’s easy to illustrate this in hindsight, it's understandably difficult to live through the ups and downs of daily liquidity in real-time. For this reason, we must view liquidity and daily market prices as an incredible advantage to our investments and not let that advantage affect us psychologically.
In closing, if you treat your public investments like your private investments, you’ll realize that the daily price movements of public assets are simply the cost for immediate liquidity—they’re a feature, not a bug. If you don’t like the price, then don’t sell, just like you wouldn’t sell your farm or house.
Warren Buffet famously said that “the stock market is a device for transferring money from the impatient to the patient.” Real investing (as opposed to speculating or gambling) takes time above all else, so it pays to be patient.
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