I would like to make clear at the outset that this post is not about the attractiveness of illiquid asset classes – I will leave others to debate the merits (and drawbacks) of private equity and its counterparts – rather I am interested in the behavioural implications of illiquidity. I was reminded of the idea about there being some form of behavioural premium for illiquid investments whilst listening to this discussion between Cliff Asness and Patrick O’Shaughnessy; I also briefly mentioned this notion in my post questioning whether volatility equated to risk.
What do I mean by a behavioural premium? Let’s assume there are two identical assets, but one offers daily liquidity and is market priced, and the other is appraisal priced / valued and provides liquidity on an annual basis. I would contend that, on average, investors are likely to be better off (from a return perspective) in the less liquid structure over the long-term because of the implications for our behaviour.
Most of the behavioural problems that plague investors stem from our reaction to the fluctuations in price of an asset allied to our ability to freely trade it. It is almost certain that many of the benefits investors have witnessed in recent years in terms of greater control and transparency have come with a behavioural cost[i]. Of course, these issues relate primarily to liquid, regularly traded, market priced assets; illiquid investments have different features – two of which are particularly important when considering the implications for our investment decision making.
– Price volatility is reduced: Illiquid assets are typically valued on some form of appraisal basis, rather through than market pricing. This does not remove price volatility entirely but should lead to a significantly smoother return profile. Although we can argue about whether volatility is an adequate measure of risk, it seems irrefutable that the variability in the price of an investment influences our behaviour.
Whilst the underlying risk of an asset is not altered by the manner or frequency with which it is valued, volatility does matter. Not only does it provoke our behavioural biases (such as myopic loss aversion[ii]); but volatility is the fuel that feeds the fire of narratives that dominate our investment decision making. If we observe or experience reduced volatility, we are less likely to act because of volatility.
– Ability to trade is removed or restricted: It is simply more difficult (by definition) to trade illiquid assets. With a liquid, market priced asset there is the ability to react immediately – this can be costly, particularly if our decision making is emotion-laden[iii].
For most investors a few sensible decisions are all that is required to have solid long-term investment outcomes, however, daily liquidity and easy access to our investments means that we are forced to make investment decisions perpetually – is my asset allocation correct? What about the recent fall in value of my portfolio? Should I reduce my equity exposure as there might be a recession ahead? Market movements incite an often overwhelming temptation to act, which technology and liquidity facilitate, increasing the potential for behavioural mistakes. Illiquidity (indirectly) forces us to make fewer decisions, potentially reducing the behaviour gap.
Of course, the idea of a behavioural premium for illiquidity is something of an abstraction – liquid and illiquid assets are distinct and we cannot perfectly isolate the behavioural impact of investments with different liquidity profiles. Furthermore, an investment should never be selected on the basis of its liquidity or pricing methodology.
Investors, however, don’t have to invest in illiquid assets to capture such a behavioural premium; rather we can create a similar benefit with liquid investments simply by taking steps to reduce evaluation and decision making frequency – through making it harder to trade (limiting investment decisions) and checking portfolios less regularly (to reduce our ‘experienced’ volatility). In an era of improved technology and access such actions can feel at best simplistic and at worst retrograde, but are crucial in making and sticking with sensible long-term investment plans.
[i] Hardin, A. M., & Looney, C. A. (2012). Myopic loss aversion: Demystifying the key factors influencing decision problem framing. Organizational Behavior and Human Decision Processes, 117(2), 311-331.
[ii] Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. The quarterly journal of Economics, 110(1), 73-92.
[iii] Loewenstein, G., & Lerner, J. S. (2003). The role of affect in decision making. Handbook of affective science, 619(642), 3.