Asset allocation strategy in its most basic form comes down to three important questions:
- What is your risk tolerance?
- What is your required rate of return?
- What is your time horizon?
These questions may seem simple, but they encapsulate much broader themes which are crucial to building a well-suited portfolio. One size does not fit all when it comes to asset allocation, and it is important to have an understanding of your priorities before making any investment decisions.
Importantly, these three questions may help to determine which assets are appropriate for your portfolio, or, conversely, ill-suited, based on their liquidity.
What is liquidity?
“Liquidity” simply refers to ease of acquisition or disposition. Marketable securities that are traded in high volume tend to be the most liquid, or easy to buy and/or sell without creating wild fluctuations in price. Cash is widely considered to be the most liquid asset due to the ease with which it can be converted into other assets. Other liquid investments include many publicly traded stocks, as well as some exchange-traded funds (ETFs), and on-the-run government bonds (treasurys). These types of investments are heavily regulated and homogeneous due to their status as publicly traded securities.
In contrast, private stock and hard assets such as real estate are often far less liquid, as they are traded in lower volume and less frequent transactions. Private equity funds, hedge funds, and other private investment vehicles are typically known for their low liquidity and lower beta, or correlation with the broader stock market. While these so-called “alternative investments” consequently offer diversification benefits, they are not suitable for everyone.
Benefits of Liquidity
The benefits of investing in highly liquid assets are many. Public, exchange-traded investments offer a high level of pricing transparency and the flexibility to sell when necessary. For an investor with a short investment timeline, publicly traded investments are the most suitable investment options. They are typically open for all investors to purchase, regardless of net worth, and minimums to invest are usually affordable for accredited and unaccredited investors alike.
Drawbacks of Liquidity
Unfortunately, along with the many benefits of liquid assets, there are also many drawbacks. Given the public nature of these securities, they are highly vulnerable to fluctuating market sentiment in times of tumult. Negative global headlines may send a highly liquid stock plummeting even if the impact to the company is likely to be negligible. Further, given complexities created by index arbitrage and algorithms, individual stocks and equity baskets may behave in ways that seem out of line with their fundamentals during short time periods.
An often overlooked issue with liquid assets pertains to pricing: inherent in every liquid asset is a liquidity premium due to the optionality and flexibility provided. Conversely, this optionality is lost in restrictive illiquid assets, which limit the investor’s ability to change investment strategies opportunistically and invest elsewhere within a short timeframe. As a result, the market dictates that an investor must be compensated for the lost flexibility, and added risk, when investing in illiquid assets. This can mean potentially higher returns for less liquid alternatives.
Why Illiquid Investments Are Important for Diversification
As a result of the many benefits less liquid assets often provide, some investors with long time horizons prefer the diversification benefits inherent in these assets due to their lower beta, or lower correlation with the broader stock market. These assets also tend to be less volatile, meaning their values are likely to remain more stable over time, since their pricing is not updated, or “marked to market,” on a regular basis like publicly traded securities.
Low beta investments are useful in down markets since they may help to minimize portfolio losses.
Illiquid Assets Have Drawbacks, Too
Although less liquid alternatives may be great for diversification, they may also involve higher risk, longer lock-ups, and lower pricing transparency due to infrequent transactions. For those still interested in participating, the ability to invest in lower liquidity assets has historically been limited. Due to high minimum investment size requirements and legal restrictions pertaining to who can participate, it may be difficult, if not impossible, for an individual who is not exceedingly wealthy to invest, or sufficiently diversify outside of these investments. This consequently has limited their availability and utility for the vast majority of the population until recent changes in crowdfunding regulation and the introduction of certain online platforms.
In summary, less liquid alternatives are typically best suited for investors with a high risk tolerance, high required rate of return, and long time horizon.
- What is your risk tolerance? High.
- What is your required rate of return? High.
- What is your time horizon? Long.
As it might take years to see returns, or have the chance to exit, investors typically must approach less liquid assets with a 5-10 year time horizon.
Illiquid investments may be beneficial due to their lower day-to-day volatility and correlation to the stock market. Due to the higher risk imposed by low liquidity, these assets often command higher returns.
Although there are many benefits to illiquid assets, they also come with many risks. It is important for each investor to understand the asset allocation strategy best suited for their needs before considering illiquid alternatives.