There are many different types of risk in the investment universe. Market risk is the possibility of an investor experiencing losses due to factors that affect the overall market performance; it is sometimes referred to as systematic risk, as it cannot be avoided. Market risk is one type of risk that touches all asset classes. An investment cannot exist without a market to buy or sell it in. Other types of risk are more specific to a certain asset class. Take interest rate risk for example; this is only a consideration in the fixed income world. It is the potential for investment losses that result from a change in interest rates. If interest rates rise, for instance, the value of a bond will decline.
Another risk that is present in all asset classes is liquidity risk. This risk deals with the relative ease of selling an investment in a market. For example, some of the more popular ETFs have over $100 billion in assets, with an average daily volume exceeding $10 billion. Moreover, heavily traded securities like these can be bought or sold from the convenience of your mobile phone. These investments have very low liquidity risk. On the other end of the spectrum are assets like real estate and private equity. How easy is it to sell a house? Even if you know you have a buyer, think of all the parties that can be included in a real estate transaction; a mortgage broker, a lender, an agent, not to mention you’ve got to find another house to live in if you’re selling your current home.
Liquidity risk is traditionally viewed as a negative; the harder it is to sell an investment the less attractive it is. However, isn’t it also true that the easier it is to pull the trigger on a buy or sell the more likely it is that an investor will rush into the decision and perhaps regret it later on. Sometimes the illiquidity of an investment can protect you from yourself. It is much harder to impulsively sell a piece of real estate than a mutual fund. This is one reason I like real estate as an investment. Among other advantages, there is no ticker or constant updating quote of the value. In contrast, think of all the 401(k) investors out there who sold their holdings in a down market because they just couldn’t watch the value go down anymore.
At the end of the day, liquidity risk is only bad if you need to sell an investment, not if you want to. Sometimes an investor just needs some help determining whether one needs to sell or just wants to. Seeking the advice of a CERTIFIED FINANCIAL PLANNER™ may be the best way to determine your liquidity needs verses wants. It may also be the best wat to protect you from yourself.