Liquidity is like a Gift from Grandma

by JT McGee

Liquid investments do not live up to the hype.I’ve been thinking a lot about liquidity lately, and have tried to assign it a value.

I thought first to pawn shops and mortgage brokers. Both of these companies sell liquidity at two entirely different price points. Yet, each have enough revenues to stay in business. So, apparently, no one else knows how to value liquidity either.

Conceptualizing Liquidity’s Value

Two different people will always value the same thing in entirely different ways. So maybe liquidity is a financial topic just like any other—“it works for me, so…yeah.” If you’ve read this blog for more than two posts, you know I hate that answer. It won’t be good enough today!

My inner contrarian tends to think that we think about liquidity in all the wrong ways. For example, gold hits all the criteria of liquid investments in that:

1) It’s commodity; one ounce of gold is one ounce of gold.
2) The price is well-known
3) You wouldn’t have to discount it to sell it in quantity.

Once we extend the importance of liquidity past a few days or weeks, liquidity starts to look really costly. More directly, liquidity today might not be a benefit if we pay for it with extended periods of depressed prices. Isn’t the goal of liquidity to avoid discounting an asset too far below market value?

The above chart reflects the price of gold over the past 30 years. I’m just going to throw it out there: there have only been a few good times to sell gold. That doesn’t necessarily mean that every other time was a great time to buy gold, but the point is that there have been very few good times to get out.

The same thing goes for housing. Housing is, compared to gold, horribly illiquid in the short-term. But, relative to gold, housing prices have been far more stable for far longer periods of time. Of course, the best time to be a seller in the housing market was most recently. Whether or not you could see that potential, however, isn’t really the topic at hand. Breaking free from the horrible human defect called recency, we know that housing has been fairly stable in value.

Liqudity’s Gotcha!

Liquidity is obvious engrained in the same thinking that makes people poor—time preference and immediacy.

In looking to the gold chart, we see that even though we could potentially sell any amount of gold at any time, there were only a few times at which we’d really want to ditch our gold. Housing, on the other hand, remains fairly constant in value, but is horrendously illiquid in the short-term.

WTF is your point, dude?

We can use some financial algebra to conclude that investors put a much higher price on liquidity than it might otherwise be worth. It was theorized in the 1980s (and I think this is applicable today) that investors would happily accept a real rate of return of negative 5%, pending that it was entirely predictable. Now, we’ve accepted this theory to assume that investors value certainty, but in this case I think it’s really all about liquidity. Price is a function of supply and demand, and also time.

Money’s “price” is well understood, and cash is a very liquid, sometimes short-term investment. Since we know how financial markets work, we know that cash is one of the best ways to achieve a negative real rate of return. The long-term value of cash is hardly certain (we know only that its return will be negative); we are far more certain that cash is, as it always has been, extremely liquid. It’s the destination by which we define liquidity.

So, in short, liquidity has a value. In my view, liquidity, much like your first home, a gift from your grandmother, or your beloved first car, is far more likely to be over-valued rather than under-valued, due mostly to the fact that some of the most liquid markets have some of the worst historical price trends.

{ 4 comments… read them below or add one }

PKamp3 November 21, 2011 at 12:37

Negative 5% sounds about right – or perhaps more if you consider credit cards, payday loans and the like (loan sharks?) as liquidity tools.

However, the recent housing bubble proves people will turn away from liquidity if they think the price is right – so it is tough to put a number on it. The other thing about the housing bubble? It increased liquidity since houses sold quicker than they otherwise would have.

And isn’t an emergency fund a drive for liquidity at the expense of yield? I can get at my stock holding in three days, assuming it’s a weekday… but I can access my emergency fund today. I’d love to see a number put on it, however.

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JT McGee November 21, 2011 at 12:48

Emergency funds are very much a drive for liquidity at the expense of yield, and capital gains. I had another paragraph touching on this, but I nixed it in the final hour. I think it’s especially interesting that liquidity is most important for two ends of the wealth spectrum–those who are rich, and those who are very poor.

If you’re wealthy, you’re more likely to value cash, as it keeping money in cash secures your wealth absolutely. On the other hand, if you’re poor–or a recent Dave Ramsey convert–you’re very big on liquidity since the lending mechanisms most available to you are, well, not exactly the best deals in the world.

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101 Centavos November 22, 2011 at 15:53

Many a mental bubble’s been popped at a yard sale, when sellers’ perceived value of their assets couldn’t be realized. “Honey, we can always sell this at one of our yard sales” Um, only if you find a willing buyer.

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Ron November 22, 2011 at 20:56

Yep, we all got to love those negative returns. it is really easy to forget just how valuable liquidity is when all is going well. Though, throw in a little financial crisis [ie 2008] and the value of liquidity is all so present.

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