The benefits of illiquid assets
It seems very hard to comprehend that there may actually be some benefits in holding illiquid assets, especially after all the problems over the last few years. To fully understand why this is the case or why it should be considered you need first ask the three most basic questions related to investments:
- How long are you looking to hold your portfolio for?
- What is your tolerance to risk?
- What realistically is your required rate of return?
These questions all need to be answered honestly in order for any advisor to start to build an appropriate investment portfolio. No portfolios are exactly the same although many are very similar. Once these questions have been answered we can start to understand the benefits of holding illiquid assets, although of course they won’t suit everyone.
What is liquidity?
“Liquidity” refers to how quickly an asset can be bought or sold without causing drastic fluctuations in its price. Often people will refer to liquidity as how quickly something can be turned into cash and although not strictly 100% correct is a good way of gaining a basic understanding.
Cash is generally regarded as the most liquid asset, shares traded on stock exchange, gold and government bonds are liquid, mutual funds are liquid too but may have redemption penalties so this needs to be considered. Investments that are far less liquid include shares in private companies and real estate. Alternative investments can be illiquid but it depends on what they are in and should be considered on a case by case basis.
Advantages of liquid assets
Liquid assets are often promoted by financial advisors as they give far greater flexibility than illiquid assets. They tend to be fairly transparent in their nature and they do not need large sums to be invested at the onset making them more attractive to many smaller investors. Liquid assets are also good for those with smaller portfolios who made need cash unexpectedly. Investors with short term investment horizons should look more at liquid assets.
Disadvantages of liquid assets
Liquid assets tend to suffer from greater fluctuations in price as they can be easily traded. For instance, negative publicity about a company may result in large numbers of shares being sold causing the share price to plummet. Unrelated global events can also result in there being “runs” on shares again causing prices to drop unexpectedly.
Liquid assets often have a ‘price’ for owning them, often referred to as the bid-offer spread and this can easily be overlooked. Also, investors will need to be compensated for owning illiquid assets as they don’t have the potential for opportunistic investing and also, they lose that flexibility. They are often rewarded with higher returns – often not the case with liquid assets.
The importance of holding illiquid assets
Illiquid assets tend to have a lower beta, or lower correlation with the stock market. They are therefore great for offering more diversification especially if you have a longer investment horizon. Illiquid assets tend to be far less volatile something that can be extremely reassuring in periods when the stock markets are struggling.
Low beta investments are popular during these times as they help to minimise losses especially if the portfolio is a little overburdened with stocks and shares.
The downside of illiquid assets
Illiquid assets are harder to value as the number of transaction are fewer, generally they are higher risk (although this isn’t always the case especially when you consider real estate), and your money is tied up for longer – think how long in can take to sell a house.
Illiquid assets often require a higher initial investment and are therefore not open to everybody. They are also not ideal for SOME people who are looking to diversify as they would simply form too high a percentage of your portfolio.
Really, illiquid assets are best suited to those with larger portfolios. There perceived higher risk is rewarded by their higher returns, but this only comes into play if you have a longer investment horizon. More often than not, the investments need to be tied up between five and ten years which again can rule many investors out.
There are lots of benefits to holding illiquid assets but they need to be considered on an individual case by case basis. Higher risk investments certainly aren’t for everyone so you need to speak to a reputable advisor who can discuss your own personal needs and requirements.
If you would like to discuss the possibility of including illiquid assets in your portfolio, why not contact Emerging Trend Advisors.