By LouAnn Schulfer, AWMA®, AIF®
Accredited Wealth Management AdvisorSM
Accredited Investment Fiduciary®
It’s a question that isn’t asked or understood enough: What amount of commitment does your investment require?
For those with a few decades of life experience such as myself, I don’t have to point out how our culture has changed to one of instant gratification. That has actually become the case for some people with their behavior toward their investments, even though by its fundamental nature any investment should be held, and therefore judged and managed, for the long term.
There are liquid and illiquid investments. An investment with daily liquidity is one that is bought and sold on an open exchange and can be traded daily. An illiquid investment is one that an investor buys into, knowing that they cannot put an order in for redemption on any given trading day and sell out immediately; the investor makes the commitment to stay invested over the long term. Buying a piece of real estate as an investment, or putting money into a business that you wish to develop are both common examples of investments which require a long term commitment. Any prudent investor would expect that if they make the commitment to one of those investments their money will remain dedicated for the long term, and it would be premature to judge or sell either of those investments without the proper time for appreciation. The appraised or mark to market value of illiquid investments likely won’t show a steady and consistent rate of return and therefore needs to be judged for their success with a longer term commitment in place. After all, there are market cycles, tangible capital improvements and time necessary to realize their effects to produce a return, availability of buyers and comparable properties or businesses to base your decision on as to whether to hold, invest more, or sell. Personally owned real estate or a business are just two examples of illiquid investments; there are others. That concept of illiquidity seems rather easy to grasp when you have direct ownership of an investment, like you would with the above examples of real estate or a personally owned business. For investors with illiquid investments that are not directly or solely owned by them, it’s good to be reminded that the principles of illiquidity and commitment are quite the same.
Even common investments that are daily liquid, such as those you can purchase in your 401(k) or in a brokerage account should be held with enough time to allow performance to play out, usually over a full market cycle. Investors sometimes forget this and proverbially shoot themselves in the foot by letting their emotions overtake their intellect, getting in and out at the wrong times, because they can buy or sell on any given trading day, as the investment has full liquidity. For these types of investments, when the investor says “jump”, the advisor, sponsor or manager has to say “how high”.
Let’s say that starting today, you are going to become an investment manager for other people’s money. You are going to manage $2 billion for 10,000 investors. If the money that you are managing is liquid, any given investor on any given day can put a redemption order in to you and you must sell shares or assets by the close of business that day. Your action to sell is not based upon whether you believe it is the right time to sell those particular shares or assets, rather, you must find a buyer by the end of the day because you have an investor who wants out and you must honor that request by the close of business that day. Now let’s say that you are managing the same money for the same number of investors, but the money is illiquid, meaning it is not traded on an open exchange. The significant difference is, you set the expectations for the holding period of the investments from the start of the capital raise. You let your investors know that you will buy assets on their behalf, manage them for a period of years, then employ a strategy to sell the assets when the circumstances are right for the sale of the particular asset. At that time, you will return the investors’ money and share of profits (or losses) to them.
Now, if you are the investor and not the manager, this is still a huge difference in the way that your money is being managed when you consider that the other 9,999 investors in this example greatly influence the behavior of the manager of the investment that you are in. If the investment is fully liquid, when any of them says “sell” the manager has to say “how much” and have the transaction completed within the business day, every day that individual investors put buy or sell orders in. Therefore, when you are participating as a shared owner of those assets, your portion and resulting rate of return are affected by the behavior of others in your investment.
So, why does understanding liquidity and commitment matter? It matters a great deal, because understanding the long term fundamental nature and commitment to an investment can guide your decision making and rationalize unnecessary emotions. If you truly understand the time needed and the nature of your investment, you’ll be more likely to have better results.
Investing involves risk including loss of principal. No strategy assures success or protects against loss. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC. Accredited Wealth Management Advisor SM and AWMA® are trademarks or registered service marks of the College for Financial Planning in the United States and/or other countries. The Accredited Investment Fiduciary® designation is earned through the Center for Fiduciary Studies.