How Liquid Is Your Portfolio? Analyzing Investment Liquidity

by Todd Smith on 2010-12-192

How important is it to consider liquidity when you build your stock portfolio?

What I find particularly fascinating about the financial industry is that you will find many more gray areas than you will actual black and white science. This leads to an ongoing debate over how far the performance of stock market research has come. For instance, Roger Ibbotson discovered another dimension in the landscape of investment performance analysis: liquidity. Though this discovery was published first in 2007, I was just recently reminded of it after hearing his latest speech on the topic. From what I gather, this newest concept of portfolio construction (which would include liquidity as a consideration) shows some promise.

What Is Investment Liquidity?

Most of us have learned the different characteristics of small-cap, mid-cap, and large-cap stocks. And, many of us have also heard about the ongoing debate about growth vs. value stocks. When people talk about “premiums,” they are referring to certain asset classes that pay a premium over others.

Investment Liquidity
Image from Randy OHC @ Flickr

For instance, if you look at things historically, small-cap stocks have paid a premium or performed better than mid- or large-cap stocks. Some studies show that, much like small-cap stocks, value stocks outperform growth stocks in the end. However, Ibbotson touts that investment liquidity adds yet another dimension for us to consider. Though intuitively I knew that liquidity (defined as how quickly and easily investments can be converted into cash) played a role, I never really considered its actual numbers and performance.

The Role of Investment Liquidity in Performance Analysis

Ibbotson researched 3,500 U.S. stocks (by quartile) that were rebalanced annually from 1972 to 2009. Based on the liquidity and size of the stocks, he analyzed their performance through almost four decades and came to some very interesting conclusions. Small-cap stocks — found to be highly liquid — performed the poorest. They returned only 5.9% per year throughout the research period. Ibbotson explains that these small-cap stocks have not been inflated adequately. On the other hand, throughout the research period, illiquid small-cap equities created the best returns, generating an incredible 17.87% yearly return over that same timeframe. It’s likely that these returns are from smaller companies that have gone unnoticed and that invite very little concern or exchange activity.

Even though we also find this tendency with large-company stocks, illiquid large-company stocks provide a much smaller premium. Large companies returned less than ten percent for their most liquid assets, while companies logged a little over twelve percent in yearly gains — through almost a forty-year-period — for their least liquid stocks. A gain of nearly three additional percentage points is huge, in my book.

Growth shares that are highly liquid — you know, those that most people are familiar with and most portfolio managers own themselves — did pretty badly, returning only a little over three percent per year throughout almost four decades. There are reasons people lose money when they invest, and it may be worthwhile knowing how trading stocks can make you poor. Now during this same forty-year research period, companies with the smallest liquidity rate provided their investors with almost twenty-one percent annually in gains!

How Liquid Is Your Portfolio? The Bottom Line

So, what’s my take? While this has not been a criterion in my tactical portfolio construction, I think that it only makes sense to be aware of the part that liquidity plays, and we’ll just have to wait and see how future research pans out. Most of my portfolios are very liquid, and I think we need to keep in mind that illiquidity also has its risks. However, at the end of the day, I always come back to a balanced portfolio using effective asset allocation strategies.

Even though research shows that there may be some outperformance in small-cap and value stocks, I would not necessarily recommend overweighing in these areas. It is very important to maintain an even mixture of growth vs. value stocks as well as small vs. mid- and large-cap stocks. And I suspect the same is true of liquidity. We would not necessarily want to overweigh our portfolios with all illiquid stocks. Rather, a balance of both liquid and illiquid investments is prudent. My reasons are twofold: first, oftentimes you simply cannot start overweighing an investment style or area without incurring more risk; and secondly, just as is the case with any historical investment performance, it’s just that — historical (remember that past performance isn’t indicative of future results).

Will this hold true with the markets as we move forward? And what is the required economic climate to support this hypothesis? Of course, you may consider me to be a more conservative or prudent investor, as my contention is that we should aim for the risk-adjusted returns we “need” rather than the best absolute returns possible.

Copyright © 2010 The Digerati Life. All Rights Reserved.

{ 2 comments… read them below or add one }

krantcents December 19, 2010 at 6:25 pm

Thanks for the information. The basics of investing is that you do not need the money for at least five years. Most of the mutual funds place some controls over their funds to reduce speculation and volatility. I try to keep to my asset allocation and monitor it periodically.

Squirrelers December 20, 2010 at 4:28 pm

Speaking of liquid vs. illiquid, I think that many people are finding out that homes are not the “liquid” assets that they were supposed to be 3 or 4 years ago. Liquidity, or ease of sale, can change over time, depending on the asset. Something to consider as well.

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