The writer is senior adviser at Engine AI and Investa, and former chief global equity strategist at Citigroup
Instant liquidity is a true wonder of modern finance. If that rainy day does arrive, just press a few electronic buttons and your portfolio can be turned into precious cash at minimal cost. No need to ring your broker or rummage through share certificates up in the attic. But, like most good things in life, liquidity must be used responsibly. Its abuse can seriously damage your wealth.
Let’s start by listing the benefits of financial market liquidity. As a retail investor, you can now get institutional-level access to a vast array of assets traded across global markets. Exchange traded funds allow you to adopt sophisticated investment strategies previously only accessible via expensive discretionary fund managers. You can diversify easily. You can hedge your portfolio if markets are looking frothy. This can all be done at very low cost.
You can cut your losers and run your winners. Or maybe you want to fire your underperforming fund manager. No problem. Just give notice and entrust your life savings to someone better.
Liquidity allows real-time pricing and hence ongoing accurate valuations of your portfolio. No need to wait for that quarterly broker statement.
Liquidity provides the live market prices at the core of the modern capitalist system. Scarce resources are allocated according to the signals being sent. Rising share prices (as in artificial intelligence-related IT companies right now) tell chief executives to grow their business. Falling share prices tell others to shrink.
However, instant liquidity is not always a blessing. It tempts all investors, professional or amateur, to make bad decisions. Portfolio performance suffers accordingly. For example, an annual survey by research firm Dalbar suggests that US retail investors earned 16.5 per cent from equities in 2024, compared with a 25.5 per cent return from the S&P. Most of the damage came from bad market timing. Many investors sold out during last year’s corrections, only to miss the subsequent rebound. Bad market timing decisions have been a consistent driver of poor retail investor performance since the first Dalbar survey in 1994.
Liquidity might make it easy for asset owners to fire underperforming fund managers, but most studies show that this is done at the wrong time. After termination the old fund manager usually outperforms the newly hired gun.
Liquidity, and the illusion of control that it creates, can turn long-term investors into short-term speculators. Why bother with laborious fundamental research when you can trade sentiment, flows and positioning?
Instant liquidity can contribute to bubbles. We chase rising prices but feel reassured that we can get out near the top. We usually can’t. Liquidity dries up, making asset prices drop much faster than they rose.
Liquidity also enables bad investment decisions in bear markets. Ongoing obligations mean that investors are forced to sell what they can (ie public market assets), despite the very low prices on offer.
Modern behavioural analysis means that we are becoming more aware of these weaknesses. The realisation that we are bad at picking stocks or fund managers means that many choose cheap passive funds instead, although this doesn’t always reduce the temptation to time the overall market.
The rise of private markets can be seen as another reaction to the misuse of public market liquidity. It’s much harder to sell at the bottom and buy at the top if there’s no market for the asset class. Private equity valuations usually show a smooth trend in net asset value, not the mark-to-market volatility evident in public equity portfolios.
Finance textbooks describe an illiquidity premium — investors should receive higher returns from private markets to compensate for lower liquidity. But maybe this could move to an illiquidity discount because private assets stop us repeating the usual self-harm in liquid public markets.
The current move back towards private markets makes me uncomfortable. The fees are higher and the liquidity lower than in public markets. Maybe, if we learnt to use liquidity more responsibly, then this expensive switch could stop.
How can we do this? Keep making those monthly pension or 401k contributions. Sometimes you will buy the market cheap, sometimes expensive. If you need to invest a lump sum into the market, average in over 12 to 18 months. Do the same when you need to take money out. Fix a simple asset allocation rule (say 60 per cent equities, 40 per cent bonds) and stick to it. Reallocate once a year. You can buy cheap funds that will do this for you.
I am not saying that liquidity is a bad thing, but it can make us do bad things. Minimise those and the benefits of public markets can shine through.
