Introduction:
Here, we will examine the benefits & drawbacks of both liquid and illiquid investments. The asset allocation strategy has three fundamental questions in its most basic form.
We examine the benefits and drawbacks of both liquid and illiquid investments.
In its most basic form, asset allocation strategy boils down to three key questions:
- What is your level of risk tolerance?
- What is the expected rate of return?
- What is your time frame?
These questions may appear straightforward, but they encapsulate broader themes critical to developing a well-suited portfolio. Regarding asset allocation, one size does not fit all, and it is essential to understand your priorities before making any investment decisions.
Notably, the answers to these three questions may help you determine which assets are suitable for your portfolio or, conversely, which are not.
Liquidity is the ease that can be acquired or sold. High-volume traded marketable securities are the most liquid or easy to buy and sell without causing wild price fluctuations. Because it can be easily converted into assets, cash is widely regarded as the most liquid asset. Many publicly traded stocks, as well as some exchange-traded funds (ETFs) and on-the-run government bonds, are examples of liquid investments (treasury bonds). Because they are publicly traded securities, these investments are heavily regulated and homogeneous.
On the other hand, private and hard assets such as real estate are frequently far less liquid because they are traded in lower volume and less frequent transactions. Private equity, hedge funds, and other private investment vehicles have inferior liquidity and low beta, or correlation with the broader stock market. While these so-called “alternative investments” provide diversification benefits, they are not appropriate for everyone.
There are numerous advantages to investing in highly liquid assets. Public, exchange-traded investments provide high pricing transparency and the ability to sell when needed. Publicly traded investments are the best option for investors with a short investment timeline. They are typically available for all investors, regardless of net worth, and investment minimums are usually affordable for accredited and unaccredited investors.
In the form of purchasing power, liquidity enables financial independence. Account holders have rapid access to liquid assets in their accounts, allowing them to make large or minor purchases. Cash-holding investors and consumers can act quickly to obtain a good deal on everything from apparel to real estate. Low cash reserves limit the ability to perform.
The top two reasons for liquidity have assets to pay your obligations and having an emergency fund for unexpected and unexpected expenses. Also, have some funds available to take advantage of incredible investing possibilities!
Unfortunately, numerous disadvantages exist, along with the multiple advantages of liquid assets. Because of their public nature, these securities are highly vulnerable to fluctuating market sentiment during times of turmoil. Negative global headlines may cause a highly liquid stock to fall, even if the impact on the company is likely minor. Furthermore, due to the complexities introduced by index arbitrage and algorithms, individual stocks and equity baskets may behave in ways that appear inconsistent with their fundamentals over short periods.
A frequently overlooked issue with liquid assets is pricing: every liquid asset carries a liquidity premium due to the optionality and flexibility. On the other hand, this flexibility is lost in restrictive illiquid assets, which limit investors’ ability to change investment strategies opportunistically and invest elsewhere in a short timeframe.
As a result, the market requires that an investor be compensated for the lost flexibility and increased risk associated with investing in illiquid assets. This could mean higher returns for less liquid alternatives.
Why Are Illiquid Investments Necessary for Diversification?
Because less liquid assets frequently provide numerous benefits, some long-term investors prefer the diversification benefits inherent in these assets due to their lower beta or lower correlation with the broader stock market. These assets are also less volatile, which means their values are more likely to remain stable over time because their pricing is not updated, or “marked to market” regularly as publicly traded securities are.
Low beta investments are beneficial in down markets because they can help to reduce portfolio losses.
Illiquid Assets Have Drawbacks As Well
Although less liquid alternatives may benefit diversification, they may also be associated with higher risk, more extended lock-up periods, and lower pricing transparency due to infrequent transactions.
Those interested in participating have historically had limited access to insufficient liquidity assets. Due to high minimum investment size requirements and legal restrictions on who can participate, it may be difficult, if not impossible, for a non-extremely wealthy individual to invest or diversify sufficiently outside of these investments. As a result, until recent changes in investment regulation and the introduction of specific online platforms, their availability and utility were limited for most of the population.
Less liquid alternatives, in summary, are typically best suited for investors with high-risk tolerance, a high required rate of return, and a long time horizon.
What is your level of risk tolerance? High.
What is the expected rate of return? High.
What is your time frame? Long.
Investors must typically approach less liquid assets with a 5-10 year time horizon because it may take years to see returns or have the opportunity to exit.
Because of their lower day-to-day volatility and correlation to the stock market, illiquid investments may be advantageous. Because of the increased risk imposed by inferior liquidity, these assets frequently command higher returns.
Although illiquid assets have many advantages, they also have many risks. Before considering illiquid alternatives, each investor should understand the asset allocation strategy best suited to their needs.
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