Alternative investing presents a whole new universe for investors to pump up their portfolios by adding resources that have the inherent capability to generate non-correlated returns. Alternative investments differ from stocks and bonds, and liquidity is one of the reasons why.
Most investors battle with comparing and contrasting liquid and illiquid investment opportunities, since both have unique properties that give different benefits and risk factors.
What are Alternative Investments?
An alternative investment is an investment in assets apart from cash, stocks, or bonds. Alternative investments can be investments in tangible assets such as artwork. They can also be financial assets such as real estate, private debt, hedge funds, or private equity.
Alternative investments tend to present a low correlation with conventional investments. It’s also hard to determine the exact intrinsic value of alternative investments, say, for example, real estate, that needs to be sold to really know the value of the asset.
Alternative assets have comparatively low liquidity, as compared to traditional investment ventures, and sometimes high purchasing costs. Some, have a minimum investment amount, lock-up periods, early redemption penalties, and a management fee.
What is Investment liquidity?
In simple terms, liquidity is how easy it is to turn your assets into cash. It’s how quickly your investments can be sold on the secondary market. Liquid assets can quickly be turned into money without losing value or incurring any hefty fees. Cash is the most liquid asset because of easy access through a bank account.
Liquidity allows you to cover basic living expenses and handle emergencies as soon as they arise. The drawbacks of liquid assets are that their value is affected by fluctuating market atmospheres, especially during crises. These may be global pandemics or any other negative global headlines which plummet liquid asset value.
Another overlooked issue with liquid assets is the pricing, which is affected by markets and simple demand, lately, academic research has proven that traded assets are primarily influenced by behavior patterns and not by market realities. This means that basically, we are linking the value of our assets to emotions.
Low alternative investment liquidity can be attributed to the lack of a centralized market, the time it takes to realize and liquidize a real estate portfolio for example, and low demand for assets (like antiques and art) as compared to conventional investments.
Liquidity is more of a spectrum than a black-or-white situation. At one extreme are illiquid assets which are very hard to value or sell for money, and at the other end, we have cash, which is the most liquid asset.
Why Does illiquidity Matter?
While liquid assets are important for day-to-day living, the more liquid an asset is, the lower its chances of increasing in value over time. An asset like cash is subject to inflation and a reduction in purchasing power over time. To protect against this, illiquidity comes into play.
Illiquid assets are not easy to value or sell for cash. Some examples are real estate, intangible assets (intellectual property, corporate goodwill), stock options, and estates. These are hard to assign a price to since they’re traded in low volumes and have less frequent transactions.
Illiquid investments are useful because of their high tendency to increase in value over time and to often be immune to inflation. Their value is also not affected by day-to-day stock market volatility, and they fetch higher returns in the long run compared to traditional investments.
It’s important to have illiquid assets to diversify a portfolio and isolate it from the broader market by tapping into non-correlated gains attached to illiquid alternative investments.
How to Use Investment liquidity to Your Advantage?
One way to use investment liquidity to your advantage is by investing in a money market fund (MMF). This exploits the volatility of liquid assets by trading your cash in securities with low maturity periods. You can easily access your assets and your investment will most likely grow over time. Money market funds are a safe way to park your money, since regulators allow only securities with the highest credit ratings to trade in money market funds, creating a form of safety net for investors. This kind of security is hardly found in other fixed-income investment plans.
Investment liquidity and illiquidity have distinct benefits and drawbacks. Alternative investments mostly fall on the illiquid side of the liquidity spectrum and can be a worthy investment option if you invest wisely.