We’ll do nothing… and we’ll like it?

A liquidity premium or illiquidity premium is something that people reference in asset classes that are not as easily sold as publicly traded companies. This could be art, collectibles, private equity, or real estate. Essentially, given the investor will not have access to a readily available market or the ability to quickly convert their investment to cash, they expect to be compensated accordingly for this type of investment. In other words, the investor expects their illiquid investment to go up more than an average stock would. There is some general debate as to whether this premium exists or not. Certain studies find that there is an illiquidity premium while others claim that this does not exist and that the illiquidity premium is not a concrete thesis behind investing in assets with a lack of liquidity.

You’re probably saying to yourself, “Cliff, this is great but I am in my twenties… how do you think I am getting exposure to fine arts and private equity investments?” Well, here is the thing; the illiquidity premium is not necessarily reserved for these alternative investments. We can apply the theory to our everyday investment philosophy.

First off, we do have access to accounts that place penalties and restrictions on the funds within them. A 401(k) is a great example of this. While, yes, we have access to these funds in the event we need them, certain penalties can be associated with taking early distributions. Thus, I will deem the 401(k) a restricted account for the purposes of this piece.

A quick bit of fascinating knowledge for everyone: retail investors (us, regular people) tend to underperform the S&P 500 (a broad index of large US companies) by nearly 2% annualized over long time frames. Dana Anspach does a great job covering why we tend to underperform in her article here. This essentially proves that the majority of retail investors would be better off buying and holding and turning their emotions off versus trying to actively manage their portfolios. 

It seems so straightforward, you will see hundreds of posts on X/Twitter saying, “It is really as simple as buying index ETFs and letting them grow.” No, it is not that simple. They forgot to mention human psychology. We are notorious for letting our emotions drive our investments, buying the highs, and selling the lows. We come programmed with a self-destruct button that sits between our ears when it comes to investing. Do you remember 2021? As cryptocurrencies soared everyone and their mother became interested in the asset class and this was after the market had already risen 3-fold. A classic instance of FOMO.

So, even though the average investor underperforms the index (something that everyone has access to through mutual funds or ETFs), how can we try to avoid this? We view our investments as illiquid. 

I started this piece by mentioning a specific retirement account, the 401(k). In my professional experience, I have never once seen someone say they wish to rebalance their 401(k) to a more conservative allocation or turn off their automatic contributions even amongst the wild volatility we saw during 2022. This is a great example of how most people are emotionally unattached to this account! They allow time and compounding to do the work for them, instead of allowing the market to influence their decisions. 

This poses a massive advantage for retail investors such as ourselves! If we can psychologically detach ourselves from the investments in an account, the better chance it will have to compound without any interruptions. Brokerage accounts, on the other hand, are much more likely to be traded on a regular basis. It is plausible that due to the restrictions placed on the 401(k) and the complete understanding that this money is for the long term that we allow our emotions to subside and do not let ourselves fall victim to trading around and buying and selling positions based on emotions that are evoked through the media we consume.

A lot of professionals also make the comparison to home ownership. We’ve all heard the stories of boomers buying their homes for $50,000 for them to now be worth $500,000. This is the illiquidity premium in all its grace. You don’t check the value of your home each day, even if you did, you cannot sell it at a moment's notice. 

The 401(k) serves as a great example of how this type of account can assist us in leaving our emotions behind to allow our money to compound. However, we can also apply this philosophy to any account we have! Brokerage accounts, Roth IRAs, Traditional IRAs, any account we take advantage of! Applying the illiquidity premium philosophy to our investments as a whole will allow us to forgo the FOMO, abandon rash decision-making, and stay the course.

Warren Buffett famously said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” While we know that most of our investments are liquid, applying the illiquidity premium theory can have a significant impact on the psychological aspect of investing that we usually struggle with. It allows us to detach from all of those emotions that may build up, spend more time on the things that matter, and let our money work for us, uninterrupted. 

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