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Investors need a balance of liquid and illiquid assets
in their portfolios if they are to take advantage of potential
investment opportunities.
In the context of portfolio management, the term
'liquidity' describes how easy it is to convert an asset
into cash. An asset that is difficult to convert quickly into cash
and without significant loss of market value is known as
'illiquid'.
Cash is usually the most liquid asset, with real estate
typically sitting at the opposite end of the spectrum. Equities and
bonds lie somewhere in between, although there can be significant
variations within these broader categories. Government bonds and
FTSE 100 stocks are generally highly liquid, while smaller company
stocks and sub-investment grade bonds can be illiquid. Cash itself
can sometimes be illiquid if, for instance, it is placed on term
deposit.
Liquidity squeezed by the credit crunch
Liquidity concerns have been at the fore since the run on
Northern Rock in 2007 and the collapse of Lehman Brothers in 2008.
In the depths of the credit crisis, a dramatic tightening in the
funding market for financial institutions resulted in it becoming
more difficult for investors to sell a variety of different
assets.
In extreme cases, liquidity in some of the more esoteric areas
dried up completely and fund managers were forced to suspend
redemptions. Having invested in funds that allowed quarterly or
monthly redemptions at the outset, investors often found that they
had to wait months or even years to receive all their money back.
Moreover, the lack of buyers in the market for these types of
assets meant the price at which they could be sold was often
markedly reduced.
Market dislocation has, however, produced many opportunities for
cash-rich investors to buy decent assets at cheap prices, a
technique demonstrated to great effect by Warren Buffett. For less
liquid investments, a commensurately higher rate of return should
be sought.
The key lesson learnt from the crisis was that liquid markets
can become illiquid with surprising speed. Never was the aphorism
'cash is king' more true. That said, with interest rates at
historic lows, cash is unattractive in pure investment terms and
inflation has the effect of reducing its value over time.
Get the right balance
Overall, investors should always try to ensure that their
portfolios have a balance between liquid and illiquid assets that
is appropriate to their circumstances. In most cases, this means a
majority of liquid assets. This ensures that cash can be raised as
and when it is needed and that holdings in a portfolio can be
bought and sold quickly, so that opportunities can be taken
advantage of in these fast-changing times. It's not just the
early bird that catches the worm, but the one with ready cash to
hand as well!
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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