Staying liquid isn’t good-or bad; it’s cheap or expensive

Market volatility is at an historic extreme.  From a technical perspective, post-pandemic U.S. stock markets are behaving in a manner unseen in price history, making multi-year lows and highs in a matter of weeks. Liquidity comes at a price.

Read on to better understand why volatility is the price of being liquid – writes Andreas Calianos 

The most common piece of investment advice is stay liquid. Simply put, this is the suggestion to put your wealth in investments that can be easily converted to cash, like stocks.

This practically universal refrain has convinced millions of investors around the world that liquidity is inherently good. But as I’m about to show, liquidity isn’t good. Nor is it bad. 

put your wealth in investments that can be easily converted to cash, like stocks

Liquidity is neither good nor bad, it is cheap or expensive. And right now, it’s very expensive.

During normal market activity, liquidity is cheap. By “cheap” I mean that selling a liquid asset has only an imperceptible impact on its price.

In fact, in a rising market, if you sell a stock that’s listed at $35.25, the price you receive may even be a little higher higher—say, $35.50—because there is excess demand for that particular stock relative to supply.

But, as we’ve seen, a major event moves a critical mass of investors and they all decide to sell (or buy) at the same time.

When they sell, prices go into freefall. Last week (11Jun) the U.S. and other major global markets fell 5 to 7% in one day.  These declines are naturally scary. But it gets worse because volatility “clusters.”  This means that volatility is often condensed in time and if last week was choppy, the best prediction is that next week will also be choppy… until it’s not. 

These declines are naturally scary. But it gets worse because volatility “clusters.”

This one statement – “volatiltity clusters” – puts the lie to portfolio diversification in liquid markets. Because, when you need diversification most, everything moves together and it moves fast.

As markets sell off, perhaps you tell yourself that you won’t sell, but as you watch those numbers go down, you become too scared to hold, and you jump into the fray: You want to pull out your cash because that will make you feel safe.

In this situation, when your sell order overlaps with so many other market participants’ orders to do the same thing at the same time, you can get your money out—but you sure won’t like the price. This is the cost of staying liquid, and in moments like today, liquidity is expensive.

It’s important to note that this cost is the direct result of the volatility of liquid markets. Volatility goes hand in hand with liquidity; they are two sides of the same coin. 

Volatility goes hand in hand with liquidity; they are two sides of the same coin

Why? Because by definition liquid assets feature an easily accessible sell button. Anyone and everyone can choose to sell, all at the same time, and that produces the wild ride of the markets.

There’s actually an easy and fascinating way to see how liquidity produces volatility: by looking at price data for publicly traded real estate investment trusts, or REITs.

These securities contain income-producing real estate, and some of them are traded on the NYSE. During the financial crisis, from their peak in 2008 to trough in 2009, REITs fell almost 80 percent.

But how much did the values of the underlying assets—the real estate itself—drop over the same period? Depending on which index you looked at, the decline in the actual real estate was 20 to 40 percent. Shares of REITs and the real estate contained in those REITs are supposed to be the same asset.

They are supposed to be the very same investment. Yet the one with the accessible sell button evidences two to four times the volatility of the other. In other words: liquidity begets volatility.

The same price action is happening today, right now.  Big drawdowns occurring in public real estate, yet little significant movement in the price of private real estate.

There will, of course, be major changes in how we work, how we live and the real estate that accommodates both.   I will address this in a forthcoming article: Post-Pandemic Real Estate – What changes and what stays the same?

While some aspects of real estate may change, the nature of liquidity will not. 

Eventually markets recover and your fear dissolves

To highlight this, imagine for a second that you don’t own stocks but instead you’re holding real estate—not public REITs, but direct or passive investment in an actual piece of property or portfolio of properties. And let’s say that events have you feeling concerned about the future, and liquid markets begin to nosedive.

Maybe in this moment you’d like to divest of your real estate and convert to cash. Well, you can’t. At least not very quickly. So you sit on it. You hold instead of sell. And in so doing, you ride out the turbulence.

Eventually markets recover and your fear dissolves. In this situation, because you’re invested in an illiquid asset, you avoided the steep cost of liquidity.

In a situation like today, when we really do not know the course of COVID-19 and the temporary or lingering impacts, it also gives time to breathe and think strategically about what is next.

The fact that your illiquid real estate is not priced every day, in times like today, is a very good thing.

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