What is Financial Liquidity?
Liquidity refers to the ease in which one can buy or sell assets at current market value. Lack of liquidity refers to assets that can’t readily be sold for cash.
Cash is universally accepted as the most liquid asset class. However, there are other highly liquid assets like stocks, mutual funds, and money market funds.
Illiquid assets are things like:
What you should know about Financial Liquidity
The advantages of liquidity are obvious. Being able to sell off an investment in a short period of time and access its cash value has its benefits. Some stock investors utilize that liquidity to periodically rebalance their portfolio or to do tax-loss harvesting.
However, if you find yourself selling off your assets for immediate cash needs then you may not have a large enough emergency fund or adequate enough insurance.
As obvious as the benefits of liquidity are, the downside of financial liquidity may not be as obvious.
Financial Liquidity has a downside
When constructing a portfolio, it’s important to have assets that are liquid. However, it may not be wise to be 100% liquid. The reason I say that is because there are downsides to liquidity.
Liquidity can undermine a disciplined investment plan. For example, liquidity can exacerbate emotional investing both out of fear and out of greed. Financial liquidity can also lead to lower returns as investors miss out on potential liquidity premiums that can come with illiquid assets. Let’s dive into this further.
The DALBAR Effect
DALBAR is a market research firm that has been studying investor behavior for years. In 1994 they produced their inaugural Quantitative Analysis of Investor Behavior (QAIB). In their words, “QAIB has measured the effects of investor decisions to buy, sell and switch into and out of mutual funds over short and long-term timeframes.”
What they’ve found every year since its inception is that investor behavior leads to underperformance in the market in comparison to the index. In other words, the financial liquidity of the market allows investors to execute bad decisions. They tend to buy toward the top of a market out of irrational exuberance and sell toward the bottom out of fear of losing it all.
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