Emotional Liquidity

In the personal finance class that I teach at Coastal Carolina University, we spend some time talking about liquidity, in the context of different investments that you might have.

Some of the students have an ambition to be real estate magnates someday. I tell them that a lot of people become very rich investing in real estate, but if you invest in stocks and bonds, you can be out of your entire portfolio and into cash in a matter of minutes if you want. If you are a real estate investor, it will take you the better part of a year to get out. 

The vast majority of the time, I don’t need this liquidity, but it helps me sleep at night. If I had 22 apartment buildings and was trying to time market cycles, I would not be able to sleep at night.

But even for someone like me, who invests in stocks and bonds, liquidity can disappear sometimes. Even back in April, during the tariff panic, liquidity was very dodgy. If you wanted to get out of a position, you could still get out, but it would cost you. And there are points in history when liquidity has disappeared altogether.

Liquidity is defined as the ability to turn an asset into cash. Most of the time, it is easy to turn a stock into cash—same with a bond, currency, or commodity. If you want to turn a house into cash, it might sit on the market for six months, and then you have to do a bunch of paperwork and appraisals and inspections before you can turn it into cash. 

Markets occasionally gap—they reprice instantly, lower or higher, with no trades taking place in the space in between. Individual stocks gap all the time, on earnings, which is one reason why I prefer to invest in indexes rather than single stocks. I never want to be trapped in an investment.

People Take Liquidity for Granted

We have the deepest, most liquid capital markets in the world, and people frequently take that liquidity for granted. They think there will always be a bid there if you want to sell. And most of the time, there is.

There is a different kind of liquidity that I want to discuss, though, and let’s call it emotional liquidity. You buy XYZ stock at $100, and it goes down to $95. “Oh well, it will come back,” you say, and it goes down to $90. Then it goes to $85, $80, and $75. It has been an orderly market the entire way down, you could have sold it at any point, and you didn’t. This isn’t a function of a lack of liquidity; this is a function of your flawed decision-making.

That’s not to say that you should sell a stock at the first sign of weakness. The decision of when to sell something is very hard, and stocks don’t go up in a straight line, and if you sold NVDA/MSFT/AAPL/etc. on the first sign of weakness, you would have left a lot of money on the table. Of course, if you sell a stock on the first sign of weakness and redeploy the cash into another stock that will outperform, you haven’t lost anything.

So much of market behavior is based on people trying to minimize regret—they’ll be sad if they sell something and it keeps going up. Not the case. Leave emotions out of it. There is always another trade, so just move on to the next one and don’t beat yourself up over selling too early.

The foregoing also applies to buying stocks—you think XYZ looks attractive at $10, it rallies to $12, and you think, “Ah, I missed it,” and then it goes to $80.  “I missed it” are the three most dangerous words in markets. Now, there are two lessons here: If you have an idea to buy a stock, the key is to act on it quickly. But if you don’t act on it quickly, and it moves higher, it is still probably a good trade. Again, this is all about emotional liquidity. The bids and offers were always there, and you didn’t take advantage of them.

Balance

There is a balance. There is something to be said for being deliberate and thinking about trades before you enter them, but there is also something to be said for being decisive and acting quickly. Let’s call it being deliberately decisive. 

A good example of this is Stan Druckenmiller, who is also deliberately decisive. He does research before entering a trade… but not too much research. If the stock starts to move, he will start buying it; and if he does more research, and it supports his conclusion, he will buy more. If you wait for all the information to come in before executing a trade, you will be too late. If you do no research whatsoever on stuff, then you are going to be uninformed and outclassed in the markets.

I will admit that I lean toward doing less rather than more research on trades. Sometimes this gets me in trouble. You know that I am short private equity stocks. Why am I short private equity stocks? Because of that Blackstone Christmas video from two years ago, and because of a chart pattern that I observed on the stock. I got short on the basis of that and that alone. 

Now, I’m a sentiment trader—that’s my process—and most of the time it works for me. But in this case, it didn’t because here we are, two years later, and private equity hasn’t blown up yet. So, I have some losses to go with my gains. Again, no regrets, but if I were to do things differently, I would have put some thought into the idea that an illiquid asset class such as private equity would probably take a while to show some weakness.

And we have come full circle. The private equity people think the lack of liquidity is an asset, not a liability. Lack of liquidity is never an asset. If you invest in a PE fund, you can’t get out for 10 years. A lot can happen in 10 years. There is nothing I have high enough conviction in that I’ll lock up my money for 10 years, not even gold. Maybe I lack vision, and that is fine. I think I will get the last laugh in the end.

Jared Dillian, MFA