Risk & Allocation
Money you cannot get at is priced differently
Assets that are slow or costly to sell tend to be priced to compensate for that inconvenience, and the compensation is only worth taking if the money is genuinely not needed.
Some assets can be sold within a day and some cannot. That difference is priced, and the pricing is one of the more reliable relationships in investing.
Why illiquidity attracts compensation
Buyers of assets that are hard to exit require something in return for accepting that constraint. All else equal, they pay less than they would for an equivalent liquid asset.
The difference is compensation for a real cost, which is the inability to convert the holding to cash when circumstances change unexpectedly.
The compensation is not guaranteed and is not a free premium. It is payment for bearing a specific inconvenience, and the inconvenience is genuine.
Liquidity is a property of markets, not assets
An asset that trades easily in normal conditions may not trade easily in stressed ones. Liquidity is supplied by willing buyers, and their willingness varies with conditions.
This is why liquidity tends to disappear when it is most wanted. The moments that prompt many people to sell are the moments when few people want to buy.
Assets described as liquid on the basis of ordinary trading volume can therefore behave very differently in an episode, which is when the description is being relied upon.
Structures can promise more liquidity than assets provide
A daily-dealing fund holding slow-moving assets offers liquidity the underlying holdings cannot support. The promise is met from cash buffers and from matching flows.
Under sustained one-way pressure that arrangement fails, and the fund's power to suspend dealing is what resolves it. The liquidity was conditional throughout.
Rules on which assets may be held in structures offering frequent dealing vary by jurisdiction and have been tightened in various places over time.
The question is whether the constraint costs you anything
Someone who genuinely will not need the money for many years bears the illiquidity constraint at little personal cost, which is the situation the compensation is designed for.
Someone who might need it faces a real risk of being forced to sell at whatever price is available, which can exceed any compensation received for holding it.
Assessing that honestly is difficult, because the events that create sudden need are exactly the ones not being planned for when the assessment is made.
Liquidity is not the same as safety
A liquid asset can fall sharply in price and an illiquid one can be perfectly sound. Liquidity describes how quickly a position can be exited, not what it is worth.
Infrequent valuation of illiquid assets can also disguise volatility. A holding valued quarterly appears steadier than one priced daily, without being any less variable underneath.
That smoothing is comfortable and misleading. It flatters the apparent stability of a portfolio in a way that has nothing to do with the risk actually being carried.
Questions readers ask
Is a target date fund a good default?
For somebody who would otherwise never adjust anything, it does a job that would not otherwise get done. It is weaker where a lot of your wealth sits outside it.
What does to versus through mean?
Whether the fund stops adjusting at the target date or continues reducing risk for years afterwards. The two produce quite different allocations on the day you retire.
