Portfolio Strategies: Liquidity

Liquidity for most investors can be measured in seconds, the amount of time it takes to open a portfolio and click 'sell'.  The speed at which investors can change their minds has created a distorted environment where frantic buying and selling is the norm, and patience is old fashioned.

I want to examine what liquidity is, why you need it, and also reframe the discussion.  I think sometimes discussions about liquidity are really discussions about symptoms, not the root cause.

What is liquidity?  Liquidity is a measure that represents the ease at which something can be bought or sold in a market.

Almost all purchase or sale decisions outside the stock market involve friction in both buying and selling.  Almost everything anyone buys is illiquid, yet this doesn't seem to bother consumers.  For example consider a house purchase.  A family decides they want a new house, they hire a realtor, tour houses and eventually find one they like.  Then they place an offer and haggle back and forth with the seller.  Once an agreement is reached financing needs to be arranged, documents need to be signed and a closing date is set.  Often the closing date is a month or more in the future.  If the buyers move in and decide they don't like the neighborhood they have to endure the same lengthly sales process they just went through before they can be rid of their purchase.

Consider another example of a smaller purchase, a dress shirt.  To purchase a dress shirt you need to drive to the store, pick it out, then stand in line to purchase it.  If you get home and decide you don't like it you need to make another trip to the store, stand in line again, and conduct the return.

Anything that's purchased out in the 'real world' involves friction in both buying and selling.  Once something is purchased there's a hassle factor to returning the item and receiving your money back.  I can't think of any purchases where one can buy something, immediately change their mind and within a few seconds have reversed the entire transaction.  It's fair to say that illiquidity is part of any transaction when something is purchased.

Even cash, the golden standard of liquidity, is sometimes illiquid.  When someone wants to move cash from a savings account to a checking account it takes three days for the money to post.  Say the person changes their mind on the transaction and wants the money back in their savings account, another three days to transfer back.  A full six days for cash to make a round trip between one account to another.

When consumers understand that a transaction has considerable friction or is hard to reverse they spend a lot of time up front to ensure they're making the right decision.  I've heard people joke that many investors will spend dozens of hours researching which washing machine to buy and then spend 15m researching a stock purchase.  On the face of it this is absurd, an investment is many times the value of the washing machine, so why the time differential?  It's because the cost of making the wrong decision on the washing machine is much greater than the cost of making a poor investment decision.  If one purchases the wrong washing machine it's not an easy task to return it.  Whereas if the investment purchase is wrong it's just a few mouse clicks from a sale.

When an investor is considering either an extremely large purchase of a business, or purchasing a private business they spend a lot of time researching their decision.  Large minority, or majority investors don't have the luxury of selling off their position anytime they want.  Their sale could be interpreted as a signal to the market with the share price negatively reflecting this information.  An investor buying a stake in a private business has to consider their decision carefully because they can't easily reverse it either.

Larger holders, and private company investors also have different investment objectives compared to the majority of private market buyers.  They aren't looking to flip their shares quickly for a small gain, rather they're in the investment for the long term.  They are looking for capital appreciation, or for the company to return a portion of their profits to them as dividends.

Dividends are under-rated, they provide liquidity in even the most illiquid situations.  If a company is profitable and investors are paid out a portion of earnings as a dividend not many investors can be found complaining about the inability to sell shares.  In fact the opposite is true.  I know of a number of very illiquid unlisted stocks paying very high dividends and it's impossible to buy shares because no current holders are willing to sell!

The drive to own a liquid stock stems from two underlying reasons, the near term need for the cash, and for the optionality to change ones mind quickly after a purchase has been made.

In order to purchase more illiquid assets a strategy needs to be put in place.  Here is how I structure my portfolio in a manner that allows me to own very illiquid assets.  Money I need for near term events, which I define as five years or less I hold in a savings account.  I never invest this money, and my liquidity on it is three days.  Beyond my initial cash I own a number of stocks that are either very liquid, or moderately liquid.  A moderately liquid stock is one where I could sell out of my position in a day or two, a very liquid one is where I could sell out of my position instantly.

The bulk of my portfolio consists of moderately liquid holdings.  Some of these holdings pay dividends, but not all do.  If the market provides an opportunity for an exit then I'm willing to forgo a dividend, although I prefer one if possible.

The last portion of my portfolio I invest in illiquid stocks.  I view these in the same way I'd view purchasing a stake in a local business.  I expect to be in these holdings for a very long time.  Because of the time commitment I will only invest when these stocks trade at a significant discount, and I always want them to pay me a dividend.  I have made one exception to the dividend rule, it was for a stock trading at 10-15% of BV and a few times earnings.

When I first realized the potential to dedicating a portion of my assets to illiquid securities I came across an article with a quote from Jack Norberg, the unlisted stock king.  He suggested to the journalist that no more than 15-20% of one's portfolio be dedicated to illiquid securities.  This seems like an accurate number to me as well, I personally have 18% of my portfolio in illiquid securities.

One question I haven't addressed that some readers might be asking is "what's the point of buying any illiquid stocks at all?"  Let me answer the question this way.  If a local businessperson approached you with the opportunity to buy shares in their successful business for 4x earnings and at 50% of book value that paid a 10% dividend would you consider that investment?  I think many investors would, and investors don't need to find local businesses to invest in.  There are many opportunities like that in the current market place found in stocks that don't attract a quote daily (or at times weekly).  Its in these stocks that some of the most incredible bargains can be found.


  1. 3 days to move from savings to checking? You might need a new bank

  2. Another educational and interesting article. Thanks!

  3. The checking and savings are held at different banks. Your right, at the same bank it's same day.

    I do my checking via my brokerage account, and put extra cash in a savings account at a bank.

  4. In running a finance business, as opposed to using cash as an individual, that bank hold period can be no joke.

    I've seen short-term liquidity scares as a result: cash is needed at a specific time (e.g., for a struggling company to make payroll), and cash needs to hit the account on a specific day or before a specific time.

    While that may seem sort of irresponsible to the average person, the reality is that there's a large swath of financial businesses that cover those types of situations.

  5. Nice read. Any examples of illiquid stocks you like paying high dividends?

    1. Coal Creek, Beaver Coal, some others.. If you dig around on OTCMarkets long enough you can discover a way to find very high paying OTC stocks. Not going to drop the secret in the public, but this is a big enough hint.

  6. What sort of rule do you use for how much to keep in cash? When you say 5 years, do you mean 5 years living expenses in cash?

    Tweedy Browne figured it took an average of 3 years for stocks to reach fair value, so they figured if you kept that much in cash you'd most likely never have to sell your stocks at bad prices. OTOH, if you want to be ultra aggressive like a young Buffett, you'd always be fully invested as long as you can find something to put it in.

    For me neither of those makes sense all the time. The Tweedy Browne method seems too conservative, especially for people who are starting out since they'd probably have to forego investing for several years in the beginning and would end up worse off in almost all scenarios. On the other hand, following the Buffett policy seems pretty foolish for most people who aren't as smart, have people depending on them, and don't have 100% job security. I am thinking a straight percentage might be a good idea - keep 10% cash always, and step that number up during richly valued markets like today. Once you build up to a million or so then you start thinking about sitting 3 years living expenses in an acct earning 1%.

    What do you think?

    1. I should clarify, I think expenses that you know will come up in five years or less should be in cash. For example we save cash monthly for a new car, this just goes to a savings account. It's usually five years or more between purchases, but I still keep it in cash, I don't want to have to sell stocks to buy a car.

      I keep 6mo of living expenses in cash, but I'm not living off my portfolio either. I think when one is younger a few months of expenses in cash is key, along with savings for big things, like cars, kids etc.

      The above is all cash outside of my portfolio, it's part of our net worth, but I don't consider it investable. Inside our portfolio I try to keep a straight percentage of 10% or so. This is so I always have cash available to purchase something if I want, and I'm not caught trying to sell something illiquid, or at a bad price to fund something new.

      This can be criticized, but it seems to work for me. I guess I'm 'losing' some performance, but an alternate view is that I'm enhancing my performance because I'm not selling at bad times.

  7. How do you get financials of unlisted stocks, if you can't go to the AGM because you are no US resident. I would have to factor in some "information cost", as I do not think unlisted companies would send the annual reports to e.g. Germany. Email would be OK, too. But how do you know the information is not made up, when the company does not even file with the SEC?

    Really like your blog as a long-time reader.

    1. Martin,

      You can call or email that company, they almost always have digital copies now. Some brokerages like Fidelity/Schwab/IB send digital statements to shareholders too.

      How do you know the information submitted to the SEC isn't made up? Many Chinese companies have done it, along with well renowned companies such as Worldcom/Enron.

      With any stock do you own research, and if something doesn't make sense, or seems too good to be true pass.

  8. Can you cite the source of the Jack Norberg quote about a 15-20% limit on illiquid stocks, and post a link if possible? I'd like to go back and read the whole article.

    1. I'd google him, or google "Walkers Manual", I did a quick search but didn't find it. I remember reading the article in January of 2012, so that search history is long gone.

      Here are some fascinating articles: http://www.businessweek.com/1996/34/b3489114.htm

  9. Hi Nate--apologies if I'm doubling my reply but the one prior didn't seem to go through. Are you familiar with UDMG? Seems like a pretty ordinary doesn't-trade/related-party-heavy REIT, but has one oddball aspect that should be apparent in its 10-Qs that both makes it potentially appealing and makes it holders perhaps hesitant to talk about it.