Psychology and (il)liquidity
Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tend to pay up too much for it while underestimating the extra returns from holding illiquid assets. The overpricing of liquidity seems to be greater in equities than in bonds, in part because in equities the price is strongly influenced by "stories," whereas in bonds it is dry mathematics.
Sid Browne: Economic theory states that there should be a premium available for accepting illiquidity. What are your findings?
Roger Ibbotson: Let me start off by saying that the stocks that I study are actually publicly traded stocks. They may be less liquid than the most liquid stocks, but they're all liquid stocks. There's a strong theoretical reason why you'd expect less liquid stocks, in fact less liquid assets of any type, to be lower valued. People want liquidity, and they're willing to pay for it. Now, what's especially interesting in liquid markets is that giving up a little bit of liquidity actually can have a surprisingly big impact – by buying stocks that trade every hour, say, as opposed to every minute.
José Antonio Blanco: Could you call that a risk premium, or is it the result of market inefficiency in the sense that investors focus on certain companies?
It could be both. You can create a risk factor from a liquidity premium. But I am rather thinking of something I call a "popularity" premium. The stocks that trade the most are the most popular. And those are the ones where there is mispricing because they get to be "too" popular, as measured for example by their heavy trading. Interestingly, our measures of stocks that trade less show lower volatility. So these stocks don't really seem more risky. Therefore I don't really like calling the extra return a risk premium.
Oliver Adler: Could you discuss the parallels in the bond market in terms of what those liquidity or illiquidity premiums would look like there?
Well, first of all, bond markets are in the fortunate position of having yields to maturity that you can actually see. You know that if the bond doesn't default, you're going to get a specific return in that particular currency. And you know it in advance.
In the equity market, you can't see the forward returns in the same way. You only see the result. And since returns themselves are very volatile, it's hard to discern what the result really is.
Oliver Adler: Would you say that the stock market gives rise to more irrational behavior than the bond market?
I'm sure there is irrational behavior in the bond market, too. But yes, there is behavior in the equity market where essentially people are attracted to stocks that trade a lot. And they'll pay more for them, just as you would do with brands in the consumer market. Consequently, the return structure is going to be different among the less popular and the more popular, and that leads to mispricing. Of course, you're also going to see mispricings in the bond market, but they may be smaller and more visible, thus easier to take advantage of.
In the equity markets, you can tell stories about the stock. And the stories can be very interesting. And you can pay a lot for them. There is more information in the bond market. It's much more mathematical. The spreads are visible.
Oliver Adler: Given that the different asset classes have different characteristics, how do you deal with the liquidity issue when you put everything together into a portfolio?
People need a certain amount of liquidity. If you're going to have a lot of illiquid assets, you also need some liquid assets to meet your liquidity needs.
There's a danger in going into too many illiquid assets, like real estate and infrastructure and private equity. Some of the universities, for example, did get into a bit of a squeeze in the financial crisis. They could not get very good prices for their private equity investments. One of the benefits of the kinds of stocks I've been talking about is that they can easily be sold in any crisis without paying much of a discount at all.
Oliver Adler: But might it be possible to argue that illiquid assets could help to put a break on investors' impulses to sell at the wrong time and save them from making mistakes?
That's an interesting argument. And, of course, there is evidence that overall stock market trends go in the opposite direction of what retail investors do: retail tends to sell after the crash and buy after the rise. So if retail investors were somehow prevented from overtrading, they might perform better. But the truth is that people want liquidity even though it sometimes leads them to take the wrong actions.