Investments and Liquidity

Liquidity in your investments is a good thing—like a slice of moist chocolate cake. And like chocolate cake, you have to pay for it. But since too much chocolate cake can make you sick, why pay for more than you’re gonna’ eat?

“Liquidity” is one of those words that jargonistas use to separate themselves from the rest of the world. All it means, really, is the ease with which you can convert an asset to cash. Can you sell it quickly, or are you locked into its ownership for a stated period of time (as with a certificate of deposit)? Is there a large active market for it (as with large capitalization stocks), or is it thinly traded (as with some small cap stocks)? Or is there no market for it whatsoever (as with many privately owned stocks not traded on any exchange)? What is the commission cost of selling? And the spread between prices buyers are offering and sellers are accepting?

Now this is important: You will find generally that you have to pay a price—in the form of lower total returns—for greater liquidity. Compare the total returns on a very liquid investment—U.S. Treasury Bills that are repaid in 30 days—with the total return on an equally creditworthy investment that is less liquid because it commits you to an interest rate for a longer period of time—Intermediate Term U.S. Treasury Bonds. Here are the (geometric) average total returns over the period from 1926 through 2008.

Average total return on 30-day Treasury bills: 3.70%
Average total return on intermediate term Treasury bonds: 5.44%

The average return on the less liquid bonds materially exceeds that of the more liquid 30-day bills. So it makes sense to assess your liquidity needs carefully, and not pay for more than you need. I know what you’re thinking, “But what if an emergency arises, and I need the money?” It’s wise to expect the unexpected. But it’s like buying insurance against disasters; you also have to consider the cost of the insurance and weigh it against the magnitude of the disaster. What will it cost you in your ultimate retirement security to have a large slice of your assets held in cash?