There are several reasons to avoid illiquidity in investing, and some reasons to embrace it. Let me go through both:
- You are offered a lot of extra yield for taking on a bond that you can't easily sell, and where you are convinced that the creditor is impeccable, and there are no sneaky options that you have implicitly sold embedded in the bond to take value away from you.
- An unusual opportunity arises to invest in a private company that looks a lot better than equivalent public companies and is trading at a bargain valuation with a sound management team.
- You want income that will last for your lifetime, and so you take some of the money you would otherwise allocate to bonds, and buy a life annuity, giving you some protection against longevity. (Warning: inflation and credit risks.)
- In the past, you bought a Variable Annuity with some good-looking guarantees. The company approaches you to buy out your annuity at a 10-20% premium, or a 20-30% premium if you roll the money into a new variable annuity with guarantees that don't seem to offer much. Either way, turn the insurance company down, and hold onto the existing variable annuity.
- In all of these situations, you have to treat the money as money lost to present uses. If there is any significant probability that you might need the money over the term of the asset, don't buy the illiquid asset.
- Often the premium yield on an illiquid bond is too low, or the provisions take value away with some level of probability that is easy to underestimate. Wall Street does this with structured notes.
- Why am I the lucky one? If you are invited to invest in a private company, be skeptical. Do extra due diligence, because unless you bring something more than money to the table (skills, contacts), the odds increase that they are after you for your money.
- Often the illiquid asset is more risky than one would suppose. I am reminded of the times I was approached to buy illiquid assets as the lead researcher for a broker-dealer that I served.
- Then again, those that owned that broker-dealer put all their assets on the line, and ended up losing it all. They weren't young guys with a lot of time to bounce back from the loss. They saw the opportunity of a lifetime, and rolled the bones. They lost.
- We tend to underestimate how much we might need liquidity in the future. In the mid-2000s people encumbered their future liquidity by buying houses at inflated prices, and using a lot of debt. When everything has to go right, the odds rise that everything will not go right.
- And yet, there are two more more reason to avoid illiquidity - commissions, and inability to know what is going on.
Illiquid assets offer the purveyor of the assets the ability to pay a significant commission to their salesmen in order to move the product. And by "illiquid" here, I include all financial instruments that carry a surrender charge. Do you want to know how much the agent made selling you an insurance product? On single-premium products, it is usually very close to the difference between the premium you paid, and the cash surrender value the next day.
Financial companies build their margins into their products, and shave off a portion of them to pay salesmen. This not only applies to insurance products, but also mutual funds with loads, private REITs, etc. There are many brokers masquerading as financial advisers, who do not have to act strictly in the best interests of the client. The ability to receive a commission makes them less than neutral in advising, because they can make a lot of money selling commissioned products. In general, it is good to avoid buying from commissioned salesmen. Rather, do the research, and if you need such a product, try to buy it directly.
Not Knowing What Is Going On
There are some that try to turn a bug into a feature - in this case, some argue that the illiquid asset has no volatility, while its liquid equivalents are more volatile. Private REITs are an example here: the asset gets reported at the same price period after period, giving an illusion of stability. Public REITs bounce around, but they can be tapped for liquidity easily… brokerage commissions are low. Some private REITs take losses and they come as a negative surprise as you find large part of your capital missing, and your income reduced.
What I Prefer
In general, I favor liquid investments unless there is a compelling reason to go illiquid. I have two private equity investments, both of which are doing very well, but most of my net worth is tied up in my equity investing, which has done well. I like the ability to make changes as time goes along; there is value to being able to look forward, and adjust.
No one knows the future, but having some slack capital available to invest, like Buffett with his "elephant gun," allows for intelligent investing when liquidity is scarce, and yet you have some. Many wealthy people run a liquidity "barbell." They have a concentrated interest in one company, and balance that out by holding very safe cash equivalents.
So, in closing, avoid illiquidity, unless you don't need the money, and the reward is very, very high for making that fixed commitment.