For many investors, liquidity is something that other people have to worry about. The average investor is not particularly concerned about an equity's liquidity because most investors are not trading with enough money for this to be a problem.
But this does not mean liquidity should be overlooked altogether. There is some evidence supporting the conclusion that less liquid equities and investments produce better returns.
Illiquid returns
One of the most cited research papers on this topic was published in 1998 in the Journal of Financial Markets. In this paper, the authors, Vinay Datar, Narayan Naik and Robert Radcliffe, concluded that less liquid stocks do produce higher returns. Specifically, the paper concluded, "a drop of 1% in the turnover rate is associated with a higher return of about 4.5 basis points per month, on average."
There's also a lot of evidence that suggests public equity markets are not needed at all. It is possible to create value through private company ownership. In the most extreme example of why liquidity is not needed, after the South Sea Bubble in 1720, England banned publicly-traded securities. As Charlie Munger (Trades, Portfolio) later recounted, this did not cause the economy to crash:
"And in England, if you'll remember, after the South Sea Bubble, England banned tradable common stocks for decades. It was absolutely illegal to have a company so widely held you got a liquid market in the shares, and England did fine during that period when you didn't have a stock market."
The billionaire investor went on to note that the American real estate market is illiquid:
"If you think that liquidity is a great contributor to civilization, why then you probably believe that all the real estate in America, which is relatively illiquid, hasn't been developed properly."
The corner of illiquidity and psychology
It is not necessarily the case that an asset outperforms just because it is illiquid. Illiquidity is more beneficial from a psychological point of view. It encourages long-term investing because it is difficult to quickly buy and sell the asset, which encourages investors to look past short-term gains or losses and focus on the long-term.
The real estate market is probably the most outstanding example of this. For most people, the largest asset they will ever buy is their home. Properties are relatively difficult to buy and sell, and it can take many months to complete a transaction. Sellers also become anchored to prices.
A homeowner who paid $500,000 for a property won't sell it for less than that amount if they can afford to wait. This is a benefit of the illiquid market. If no one is buying and selling, there's no way to determine a price. The price is unlikely to increase quickly, but it is also unlikely to fall.
To put it another way, illiquidity forces long-term investing. That's why it is relatively straightforward to make money in real estate. For primary residences, homeowners are essentially locked into an asset for many years.
A similar strategy in the stock market may produce similar, if not higher returns. Investors can make the most of this by adopting a similar psychology when investing.
Stock markets are highly liquid, but that doesn't mean you have to be ready to buy and sell at a moment's notice. A monthly investment plan and yearly rebalancing are just two strategies that can be used to reduce liquidity.
Other strategies include searching out illiquid stocks, although these tend to be small caps that are inherently risky. It might make more sense to stick with liquid blue chips, but put in place some speed bumps to control your actions. Liquidity can be a mindset as well as a technical factor.
Disclosure: The author owns no share mentioned.
Read more here:
- A Look Back at Warren Buffett's Gen Re Mistake
- Warren Buffett: How to Understand the Foundations of Investing
- How to Follow Warren Buffett: Work Smarter, Not Harder
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