Types of Investment Risk: Illiquidity
Published on June 11, 2013
We are in the middle of a series breaking down the various types of investment risks. You can read the introduction here. We are posting one article covering one risk each weekday until the series is complete.
Yesterday we introduced the series and covered Inflation. Today we are covering...
Risk #2: Illiquidity
Description: A liquid investment means money is readily available or easily convertible to cash, like savings, CDs, broadly-traded stocks and bonds. Illiquidity refers to the inability to access your capital when you need it. For example, if you have invested in a partnership that has very limited liquidity, you may not be able to redeem your investment for cash very easily or without subjecting yourself to a large penalty or discount, and thus a loss of principal. Illiquidity in and of itself does not result in a loss of principal, but in circumstances where one needs to redeem their illiquid investment in a relatively short period of time or prior to the full term of the original investment, illiquidity can result in principal loss.
Primarily Applies to... Real estate, private equity, equipment, complex derivatives, or any investment that does not have a large, active market consistently buying and selling the underlying investment or investment type.
Real World Examples: You can sell a share of stock during any weekday but it would take at least 60-90 days to sell your house if you listed tomorrow. If you absolutely had to sell in a hurry, you would likely have to take a discount to market to get it done in time. Auction Rate Securities froze in the Great Recession, ending the liquidity of a market that had been fairly liquid for 20+ years. This significantly reduced the value of the ARS in a very short period of time--especially because very few saw it coming. Many investments that have redemption programs suspended these programs in 2008-2010 because they simply did not have the liquidity to provide to investors when everyone wanted out all at once.
Extreme Avoidance Measures: Keep your wealth in cash, savings accounts, stocks, and bonds. Do not invest in anything that has a lockup period or that takes a long time to buy or sell.
Potential Mitigations: Set aside the amount of money that you need to live off of to cover 6-12 months without income. Invest a portion of your capital into investments that are more liquid and ladder (i.e. diversify over various time periods) the remaining amount of your capital into investments with varying maturities such that, over an extended period of time, you have a portion of your more illiquid investments becoming liquid on a rolling basis.
Stay tuned, tomorrow's highlighted risk is: Fraud/"Madoff".