Liquidity and Volatility – Two Different Sides to the Investment Coin

Most investments can be separated into two broad categories with regard to how easy it is for an investor to gain access to his or her money: liquid and illiquid. And they can be separated into two different categories with regard to the risk of loss of capital, especially in the short term: volatile and non-volatile.

Mutual funds are one example of a liquid investment, because they can usually be sold quickly and easily via a major stock exchange if the investor needs access to his or her money. Conversely, assets like real estate and an ownership interest in a small business tend to be illiquid — since there’s usually not an exchange or ready market for these assets, it can take much longer to sell them. As a result, illiquid assets may not be the best option for investors who may need ready access to their funds.

The Volatility Lens

Now, let’s look at these asset classes through the lens of volatility. While relatively liquid, mutual fund shares may also tend to be more volatile, especially in the short term. The price of mutual fund shares may change on a daily basis, and sometimes these changes have little if anything to do with the actual value of the companies in the fund.

Illiquid investments, on the other hand, tend to be less volatile. One reason for this is because their prices aren’t constantly re-evaluated, like the price of a mutual fund might be. The illiquidity of an investment like real estate or ownership in a small business also makes it less volatile — since these assets usually can’t be bought or sold quickly or easily, their value tends to remain more stable.

When purchasing illiquid investments, investors generally should maintain a long-term time horizon — typically, five years or longer. This is because investments like these are usually intended to create growth and value over the long term. When investors remain invested in these types of assets, it enables the managers of the real estate holdings and small businesses to commit resources to long-term projects and capital improvements, and thus hopefully increase the value of the assets over time.

Consider Both Sides of the Coin

When you examine any investment, be sure to consider both its liquidity and volatility characteristics. In short, highly liquid investments like mutual funds often tend to be more volatile as well, which may make them inappropriate for investors with a lower risk tolerance. However, since it may be relatively easy to sell these investments, they may be attractive to investors who may need ready access to their funds.

Meanwhile, investors in illiquid assets should usually plan on holding them for the long term. If an investor needs to access funds quickly, it could be difficult to sell these investments — a scenario sometimes referred to as being “asset-rich but cash-poor.”

To discuss which types of investments might be most appropriate for your portfolio, given your individual investment goals and objectives, please contact David Lerner Associates at (877) 367-5960.