Liquidity Premium: The rate of return that an investor expects above other rates of return in order to make an illiquid investment. All other things being equal, an investor generally expects a higher return for investing in something that may be difficult to convert to cash.
It is remarkable how quick and easy it is to buy and sell all kinds of tradable assets like stocks and bonds (and even used cars) using your smartphone. The ability to quickly dump these assets is a blessing and a curse. In fact, algorithmic equity trading systems buy and sell millions of shares in time periods measured in nanoseconds.
This begs the question, as I pick an asset allocation, should I include assets that don’t reprice every second? What about an investment that reprices monthly or yearly or every decade?
The theory goes like this: Where there is a lack of liquidity, higher rates of return can be had in exchange for bearing this illiquidity.
Indeed, as a sea of foreclosure signs became permanent lawn ornaments six years ago, very deep discounts could be had. Those who could identify the intrinsic value in these assets did very well as the credit cycle improved, liquidity improved, and the foreclosure signs gave way to heated bidding wars.
As the search for yield has reached extreme levels and projected returns for traditional assets like stocks and bonds have been pushed down to yawn-inducing levels, the buyer’s market for classic cars, collectible art, investment real estate, private equity heated up until it had been sucked dry of profitability. While many of these assets like Monets and Manhattan penthouses are serving as a money laundering scheme for sketchy billionaires from around the world, scrappy folks can still collect illiquid assets at low prices, as more timid folks wait for sunnier days.
How much should we devote to illiquid assets? No one has a crystal ball, and all asset allocation strategies are based on only several decades of past performance. However, if you want to go back further in history, The Talmud, a rabbinical text pertaining to Jewish law, (circa 1200 B.C.–500 A.D.) offers some guidance. (Remember that this was a people ravaged by mass displacement, natural disasters, and plagues.)
“Let every man divide his money into three parts, and invest a third in land, a third in business, and let him keep a third in reserve.”
Here is how I would translate this:
- 1/3 real estate
- 1/3 private equity or public equity (including your own business)
- 1/3 investment-grade bonds + gold coins + cash
Not sure where a 1958 Ferrari 250 GT fits into the Talmud’s recommendations, but I’d plop it into the real-estate bucket, because it would look awesome in my living room.