37 - Liquidity: Risks and Opportunities

Mental Models discussed in this podcast:

• Liquidity
• Risk
• Insurance
• First Principles

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Liquidity: Risks and Opportunities - Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode37

What is Risk?

• Merriam Webster has a few definitions for us:
  • Possibility of Loss or Injury
  • Someone or something that creates or suggests a hazard
  • The chance of loss or the probability of loss
  • The chance that an investment (such as a stock or commodity) will lose value
• What this should suggest to you is that there are many different types of risk. 
• This is especially true for investing risk. Each type deserves its own discussion and it would be a mistake to believe that 
• Two Key Elements to risk:
  1. Uncertainty,
  2. Negative Event

Liquidity Risks

• Personal
  • Value of an Emergency Fund
  • Value of Life Insurance
• Investment
  • Liquidity Risk - Time to receive your money back in cash
  • More liquid stocks reduce liquidity risk

Opportunities offered by Liquidity

• Personal
  • Large sums of cash provide flexibility
    • Move across the country
    • Make investments
    • Get a good deal on a car
• Investment
  • Liquidity Opportunity - Less liquid stocks tend to have higher returns than high liquidity stocks

When is Liquidity Important?

• Time-Bound: On the personal side, liquidity is important when you need to spend a large sum of money. Can either be planned for or it is an emergency.
• When you want to sell: On the investment side, liquidity is important only when you sell a stock. You don't really care about liquidity when you are purchasing a stock. The key point is that you want to be able to sell a stock at a price close to its fair value at the time you determine you need to sell. 
  • If done optimally, you can buy illiquid stocks during your buying period and when yous ell them, they will have transitioned into liquid stocks. 

Liquidity First Principle:

More liquid stocks are better than less liquid stocks because they reduce liquidity risk. 

• "All else Equal" Considerations:
  • Unfortunately, this statement is only true when we can rely on everything else being equal. 
  • In practice, less liquid stocks tend to have higher returns. 
  • Therefore, you really have to make a tradeoff. Would you rather have low liquidity and high returns or high liquidity and low returns?
  • The reason this first principles still holds true is that there may be circumstances where high liquidity can offer high potential returns. When that occurs, it would be preferable to low liquidity options. 

Summary

Liquidity is a topic that offers both risks and opportunities. Lack of liquidity is fraught with risk, especially in your personal life. However, a lack of liquidity can offer many opportunities when it comes to investment potential. You should manage your liquidity risk across all spectrums of your life such that you can receive optimal returns with minimal risk of a total loss of principal.