Here’s Why Illiquid Investments Might Be Your Most Solid Bet
The following is adapted from The Household Endowment Model by Vince Annable.
“Alternative investments” has a nice ring to it, but what does it really mean? And why are they a great addition to the conventional stock/bond portfolio?
To begin with, alternative investments are generally private investments, instead of those made in publicly traded markets. As such, they aren’t correlated with public markets’ ups and downs.
Alternative assets also tend to be less efficiently priced than traditional securities, which gives investors the power to exploit market inefficiencies through active management. If you have a long-term horizon, alternative investments are perfect for exploiting illiquid markets like venture capital, real estate, and natural resources.
Of course, “Illiquidity” and “market inefficiencies” sound like negatives rather than positives. Most investors have a strong tendency to put liquidity first. “What if I need cash in six months, twelve months, or two years?” What if, indeed! Most investors don’t properly calculate how much liquidity they need, and liquid investments aren’t always the safest bet. Counterintuitively, illiquid investments can actually provide the greatest return on investments.
Remember the emotional, knee-jerk reaction to the crash of 2008? Investors sold when the market was at its lowest, hoping to “save” what was left. The same was true of many large financial institutions and mutual funds. Even when the people at the helm knew better — and let’s hope at least some of them did — they were forced to liquidate holdings at the worst possible time, because, in many cases, their charters forced them to.
By the time the market started turning around in late 2009, it was too late to recoup losses. The money had already gone down the drain, in large part because of so-called market efficiencies. An “efficient market” is one that rapidly reflects and adjusts to changing facts on the ground. In general, in an efficient market, securities are neither under- nor overvalued. They are priced in a way that reflects all relevant, available information.
Market efficiency and liquidity go hand-in-hand. In an efficient market, you can easily buy low and sell high. The problem is that it’s just as easy to buy high and sell low. In fact, it’s all too simple to push the panic button when the market’s roller coaster accelerates from a peak down into a valley. Illiquidity and inefficient markets can potentially save some investors from themselves.
Take a simple example: an investment in privately held commercial real estate requires a long-term commitment of capital, often five years or more. If you think you need your money back in two years, you’re basically out of luck — which turns out to be lucky in some cases.
To put this in more formal financial terms, the potentially higher returns attributed to alternative, in contrast to conventional, investments may be attributed to the “illiquidity premium.” Although several factors are at play, the more liquid an investment is, typically the less risk is involved and the lower the return. The standard risk/reward equation, with which you may be familiar, comes into play: the higher the risk, the higher the reward for success, because the chance of failure is comparably high.
In an efficient public market, information is available in real time and assets can be traded immediately. This creates a relatively uniform market in which most investors have equal chances of profit and loss. Public markets are transparent because it is illegal to trade on insider information. This market transparency delivers returns that are “symmetric” — more or less the same — for most investors.
Private markets and private investments operate with an entirely different set of rules. Private companies are not required to disclose corporate information to the public. So-called insider trading is not illegal but rather the name of the game. As a result, investors in these companies have greater or “asymmetric” access to information about company management, company financials, sales pipelines, and strategies.
In short, don’t be deterred by illiquidity. In the long run, it might be your most stable option. Market inefficiencies can give patient investors, those willing and with the financial ability to wait long enough to make illiquid investments, advantages and opportunities over investors in publicly traded, highly liquid markets. The Yale Endowment Fund, the Blackstone Group, and The Household Endowment Model (THEM) all understand and leverage these advantages for the benefit of their clients.
For more advice on the illiquidity premium, you can find The Household Endowment Model on Amazon.
Vince Annable, CRPC®, is the creator of The Household Endowment Model® and founder and CEO of Wealth Strategies Advisory Group. Vince has been involved in the financial services industry since 1981. Vince prides himself in bringing new investment methods to high net worth families. He’s had families approach him after learning his method to tell him that they didn’t understand why their own advisors hadn’t told them about it. He’s also taken his message to the public on The Michael Wall Show, ABC15 Sonoran Living, and as the host of the podcast, Your Money Manual.
