Illiquidity
Illiquidity refers to the inability of an asset to be readily and easily converted into cash without significant loss in value. Illiquid assets tend to have lower trading volume, be unique or unusual, and take an extended period of time (longer than 72 hours) to sell.
The loss of value in the sale of illiquid assets can stem from a few sources. Because of the individuality and lower volume of these assets, there tends to be a lack of immediately available buyers. This can prompt some sellers to slash prices in an attempt to make a quicker sale. In other cases, there are transaction costs associated with the sale. Fees and additional costs are common in complex sales that require lawyers or other experts, such as in real estate.
Illiquid assets are also typically traded in private markets, which lack the transparency, extensive consumer knowledge, and daily pricing found in public markets. This means that they are priced as needed and more difficult to access for most investors.
Examples of Illiquid Assets
Commercial real estate is an illiquid asset, as every property is unique and sales generally take a significant amount of time. The sale of a property can take months, requiring sellers to find potential buyers, involving negotiation, and waiting for buyers to perform due diligence. These factors, alongside transaction costs, demand pressure, and inventory risk, all contribute to the illiquid nature of real estate.
Other illiquid asset classes include collectibles, fine art, hedge funds, and cars.
Advantages and Disadvantages of Illiquidity
Illiquid investments come with a host of advantages and disadvantages for investors to consider in relation to their individual risk tolerance and portfolio strategy.
- Portfolio Diversification: Illiquid assets present an additional layer of diversification to a portfolio, helping to balance across markets, time periods, and asset classes.
- Illiquidity Premium: Illiquid investments often benefit from higher returns as a result of their longer holding periods and the level of expertise involved in transactions. While not always the case, many investors find the potential returns to outweigh the liquidity risk.
- Volatility: The slow-moving nature of private markets, lack of public trading, and tangibility of assets has historically meant less volatility for illiquid assets. While public markets often see price volatility as the result of political, environmental, and economic events, such as COVID-19, long-term investments are protected by their inability to be sold. For those who can tolerate their assets being tied up during economic downturns, an allocation to illiquid assets may provide stability.
- Selling Flexibility: The hallmark of liquid assets is their ability to sell quickly at fair market value. This provides investors with the flexibility to turn assets into cash in emergency situations, which real estate investors cannot do. While flexibility may be helpful in the short-term, less liquid, long-term investments can protect against losses from panic selling.
- Accessibility: The private market nature of illiquid assets has traditionally dictated that their transactions are primarily available to only high net worth individuals and institutional investors. However, through companies such as EquityMultiple, they are now a much more accessible avenue for portfolio diversification.
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