What Is Liquidity Exactly?
Let’s start with the basics. Liquidity refers to how easily an asset can be bought or sold in the market without significantly impacting its price. A highly liquid asset is one that you can quickly convert to cash at a fair market value. Think stocks on the NYSE or government bonds – these tend to have high liquidity. On the flip side, assets with low liquidity are tougher to sell fast, and trying to offload them can require you to take a steep discount.
Liquidity matters because it gives you flexibility as an investor. Do you foresee needing the cash soon? Then steer towards more liquid assets. Are you comfortable locking money away for years? Illiquid assets may work for you. The liquidity spectrum ranges from cash at one extreme to “hard” assets like property at the other.
You ideally want a healthy mix of liquid and illiquid holdings in your portfolio. But occasionally life throws you a curveball, and you need to sell assets quickly. That’s when low liquidity can sting.
Now that we’ve set the stage, let’s examine which investments occupy the least liquid end of the spectrum.
What Factors Impact An Asset’s Liquidity?
Before naming the least liquid assets, it helps to understand what makes an investment illiquid in the first place. There are a few key factors:
Low Trading Volume
This one’s straightforward – an asset with fewer buyers and sellers in its market will be less liquid. Think of an exotic stock with minimal trading volume versus Apple shares, which exchange hands millions of times daily.
Narrow Buyer Pool
Even if there is secondary market trading, the pool of interested buyers may be limited. Take collectibles like fine art – only a handful of collectors worldwide may want that Rembrandt painting.
Assets with more subjective valuations are tougher to price and hence less liquid. Is that Mickey Mantle baseball card worth $10,000 or $25,000? Wide bid-ask spreads indicate valuation uncertainty.
High Transaction Costs
Anything that jacks up the cost of trading, like commissions or taxes, negatively impacts liquidity.
Some assets come with lock-up periods, withdrawal limits, or other constraints that reduce liquidity. Real estate also faces zoning and title transfer regulations.
Unique Asset Characteristics
Transporting and storing physical assets like commodities requires effort, affecting their liquidity. Even financial assets like private equity funds have built-in illiquidity due to their structure and strategy.
Types Of Illiquid Investments
Now that we know what makes an asset illiquid, let’s go through some significant examples:
This includes investments in private companies not listed on public exchanges. The lack of a secondary trading market makes private equity highly illiquid. Investors often have to hold their stakes for 5-10 years as the companies mature before they can cash out via a sale or IPO.
Residential and commercial property take time to sell due to paperwork, regulations, and the need to find a willing buyer. Their chunky value also makes them harder to divide up and sell piecemeal. And good luck selling just the front half of your house!
While some commodities like oil or metals have active futures contracts that aid liquidity, physical commodities themselves aren’t so easy to sell. For example, a tanker ship full of oil sitting offshore can’t readily reach buyers instantly.
Art & Collectibles
Here we run into the double whammy of opaque valuations and a tiny buyer pool. Is that rare Pokemon card worth $100 or $10,000? You may spend months or years trying to find collectors interested in such niche items.
These include exotic financial instruments like equity-linked notes with unique payout terms. Their bespoke nature makes them hard to value and sell quickly.
Many hedge funds limit capital withdrawals to monthly, quarterly, or even annual redemption windows. Lock-up periods forcing investors to keep money in for 18-24 months are also common.
Why You Should Care About Illiquidity
At this point, you may be wondering, “Why does it matter if my assets are illiquid?” Fair question! While illiquidity can work to your benefit in some cases, it also exposes you to some risks:
Forced Selling At Fire Sale Prices
Need cash fast for an emergency? Tough luck offloading that property quickly without taking a bath on the price.
Missing Out On Other Opportunities
Locking up capital for years in an illiquid investment ties your hands. You may miss other promising investments in the interim.
Difficulty Accurately Valuing Assets
Private startups and collectibles are notoriously hard to value compared to publicly traded stocks. This uncertainty can cloud your decision-making.
Higher Trading Friction
Trying to dump an odd lot of a commodity quickly may require price concessions that eat into your returns.
In short, illiquidity introduces opportunity costs and frictions that erode your performance. You can’t treat illiquid holdings like cash in the bank when you may have to wait months or years to unlock their value.
Who Cares Most About Liquidity?
Asset liquidity concerns some investors more than others. Day traders executing dozens of trades daily will shun illiquid markets. But a pension fund with a 30-year time horizon may care less about quarter-to-quarter liquidity.
Here are some examples of investors who prize liquidity:
- Retail investors – Households wary of tying up money may prefer liquid assets to access cash for daily needs.
- Institutional investors – Hedge funds using leverage favor liquid markets that allow quick entries and exits.
- Banks – Need stable short-term funding sources to fund operations and loans. Avoid illiquid assets.
- Mutual funds – Must be able to meet investor redemptions which favors liquid holdings.
Conversely, these long-term investors tend to worry less about liquidity:
- Sovereign wealth funds – Government-owned pools investing state assets over decades.
- Endowments – Colleges with perpetual time horizons and less need for liquidity.
- Family offices – Serve ultra-high net worth families with patient capital.
- Pension funds – Retirement funds with very long duration liabilities.
So while Wall Street traders obsess over intraday liquidity, the Harvard endowment can comfortably commit capital for 10-20 years.
Strategies To Manage Liquidity Risk
Let’s shift gears and talk about minimizing exposure to liquidity risk in your portfolio with these tips:
- Maintain a liquidity buffer – Keep sufficient cash on hand for emergencies so you don’t have to sell illiquid assets at a loss.
- Diversify across liquid and illiquid assets – Don’t overload on riskier illiquid holdings.
- Buy during market downturns – As the IMF notes, liquidity often vanishes when you need it most during crises.
- Favor transparency – Assets with clearer valuation and trading data are more liquid.
- Know your time horizon – Illiquid bets may work for long-term investors only.
- Limit use of leverage – Can force the involuntary sale of illiquid assets if margin calls kick in.
With the right precautions, you can prudently incorporate illiquid investments to boost portfolio returns. Just don’t bank on rapidly flipping them for quick cash.
The Least Liquid Investment Is…
We’ve walked through a bunch of illiquid asset contenders. Now, it’s time for the big reveal…
The investment with the absolute lowest liquidity is:
Direct ownership stakes in private companies
Unlike stocks, purchasing a private business or shares in a startup offers no public market for resale. Trying to find a buyer for your stake when no platform or process exists is a monumental challenge.
You also can’t readily sell portions of your ownership piecemeal; the whole thing generally must change hands. And forget about dividends or buybacks – getting cash flowing from a private enterprise you’ve invested in is yet another illiquidity hassle.
While the high risk comes with the allure of potential outsized returns, the total lack of liquidity is the price you pay.
So there you have it – private company ownership takes the crown for the least liquid investment. Other strong contenders are residential real estate in inefficient markets, exotic collectibles with tiny buyer pools, and assets requiring specialized storage like fine wines.
Liquidity lies on a spectrum, ranging from the instant convenience of cash to investments that may take years to convert back into spendable money. As we’ve explored, assets with lower liquidity introduce risks like uncertain valuations, potential fire sale losses, and lack of flexibility. But they also offer benefits like higher potential yields over long periods.
Finding the right liquidity balance for your portfolio takes thoughtfulness. Do you have a moderate risk appetite and 5-10 year horizon? Then judiciously layering in some illiquid bets may provide excellent diversification. Just be sure to maintain enough liquid reserves so you’re not caught offsides when the markets turn volatile.
Here’s the bottom line – which investments you deem “least liquid” will depend on your timeframe, risk tolerance, and other alternatives available. But armed with the knowledge we’ve covered today, you can make informed decisions for your portfolio. The next time someone asks about illiquid investments at a cocktail party, you’ll have the perfect answer ready to go!