Who would you rather lend a hundred dollars to? A friend who promises to pay you back whenever you ask, or one who promises to pay you double in five years? Well it turns out most people want to get paid back on demand. It’s because they value liquidity. They want their money when they need it.
The same is true with investing, but investors may not understand how combining liquid and illiquid assets can balance their portfolios. You measure an asset’s liquidity by how fast you can sell it without impacting its price. A U.S. Treasury bill is a good example of a liquid asset. On the other hand, illiquid assets like institutional real estate funds take much longer to sell and their prices are less certain. To compensate, illiquid assets pay what’s called an illiquidity premium. This premium may help you generate higher cash flows from your investments.
So why is liquidity so valuable? One word: risk. With illiquid assets, you may not be able to get your money out when you need it. If you can push past this anxiety, the illiquidity premium may be very attractive. Illiquid assets may perform better than liquid funds during market disruption. For example, private real estate outperformed traded real estate during and after the 2008 recession.
So before building an all-liquid portfolio, determine how much risk you can stomach and what kind of returns you need. Illiquid assets may help boost your overall returns and limit volatility during market downturns.