You know those cheap little hourglasses that come with board games? I think they are fascinating.
They are a physical representation of time. Zero technology. Impressive accuracy. Thousands of years old.
Have you ever seen one with liquid instead of sand? Even cooler.
That’s what we will be taking a closer look at today. Not hourglasses – liquid and time.
A liquid asset or investment is one that can easily be converted to money. Illiquid is the opposite – it is more difficult to convert into money.
The stock market is a great example of a liquid investment. You can instantly sell to an anonymous buyer at the set price for that split second. It is instantaneous and has a pretty low transaction cost.
Investing in rare art is illiquid. It has significant value, but is much harder to price. You better not be in a hurry to unload it because you likely won’t receive top dollar. The price is dependent upon what someone is willing to pay – be prepared to pay a broker a huge fee to find the buyer.
Obviously liquid is preferable – you want to be able to access the money in your investments. It gives you options.
But you might have to give up something for that liquidity…
What’s the Cost of Liquidity?
If everyone wants something, the price goes up. Economics 101.
Everyone would choose a liquid investment compared to an equal return for an illiquid investment. So they are not priced the same.
A simple example is a savings account vs CD (certificate of deposit). A savings account is perfectly liquid – you can remove your money at any time. A CD is similar, but you put your money in for a set period of time determined up front – a 1 year CD is common.
Which one do you think provides the better return on investment? The liquid savings account or illiquid CD? The savings account might give a 0.5% yearly return and the CD 1.5%.
If you choose the CD over the savings account, you get an extra 1% yearly return. Or 3 times the return of the bank account.
Same money going in, but you traded your option of accessing the money at any time for a better return.
The Traditional View
Let’s take a look at the stock market since that is where almost everyone invests their money.
Average Joe wants to retire one day so he invests in the stock market. Index funds, mutual funds, individual stocks, you name it. He slowly builds up his positions over the years, purchasing more and more stock.
The investment is extremely liquid, even though Joe knows he won’t be touching that money for a long long time. He has the luxury to sell at any given millisecond, Monday through Friday.
The stock represents a piece of a company that is attempting to make money and impress investors to further drive up their stock price. The company has a shorter term view than Joe – they have to hit their quarterly numbers. They might choose to sacrifice their long term profit to drive up the numbers in the short term.
Is there something wrong with this picture for Joe? Could he use his timeline to his advantage?
The Luxury to Think in Decades
Joe knows he doesn’t need to touch the money for decades. Ok, there might be a small portion he needs to access, but not unless something really goes wrong.
Just like the CD vs savings account example, he can choose a less liquid investment that will have greater returns than the stock market.
There are many possibilities, but investment rental property is my favorite. It walks the fine line of liquidity – expensive transaction costs and paperwork make day trading impossible. Yet it has a fairly well defined price with many willing buyers (it isn’t a Picasso sketch).
And the returns over the course of a couple decades are roughly three times the stock market.
It Still Spits Out Cash Over Time
Even though the asset itself isn’t very liquid, you will still have the ability to access some of the money.
Every month the tenant pays rent – after factoring in all expenses you will get to pocket some cash every month. As the equity builds, you have additional options like refinancing to access the equity without selling the asset.
As you patiently wait over decades, you are pocketing cash the whole time. It comes at set intervals though, you can’t sell at an exact millisecond.
You are giving up flexibility for greater returns.
What do you think, can you use your timeline to your advantage?