The benefits of illiquidity

Venture capital is a relatively illiquid asset class. In other words, since there isn’t a public market with significant supply and demand which produces real-time asset pricing, it isn’t easy to sell a venture capital investment after you’ve made it.

This illiquidity is correctly viewed as an additional risk which investors earn a risk premium for taking.

However, the same illiquidity also carries an advantage. Specifically, it is a natural opposing force to the human tendency to continually check asset prices and to trade in and out of assets when driven by greed and fear.

Frequent trading behavior is known as active management and studies show that the average active investor underperforms his more passive counterpart who simply buys and holds. This is to be expected because, each time that an active investor trades an asset, they lose the spread between the bid and ask prices of the asset while also incurring brokerage fees. And the average active investor’s returns don’t improve as a result of this frequent trading behavior.

This doesn’t mean that all active investors underperform. Some of them produce higher returns than passive investors. However, in the public markets, these are increasingly computer algorithms with tremendous data processing capabilities and low latency. The average active investor, who is increasingly a processing power-constrained and high latency human, produces lower returns than his passive counterpart.

In other words, the illiquidity of venture capital makes it harder to actively manage a venture capital portfolio. It forces you to buy and hold for much longer periods of time, and that’s a good thing.

The illiquidity of venture capital is also the reason why computer algorithms have yet to displace venture capitalists. Although that day will likely come, the success of a buy and hold strategy is less dependent on sheer processing power and low latency than the success of an active management strategy. Instead, the success of a buy and hold strategy depends on having creative and often contrarian insights. That’s where, for the time being, humans still have an edge.

Originally published at Thoughts of a VC.