Fundamentals of Financial Intelligence
The Biggest Misconception about Financial Liquidity
Everything Becomes Liquid if the Price is Low Enough
There are a number of nominally simple financial concepts which are the source of endless confusion, sometimes positively nourished by the community of financial advisors and commentators, and perhaps none so egregious as ‘liquidity’.
The concept of liquidity is simple enough to understand: the invention of “capital” around the dawn of the historical modern period pivoted around the discovery that wealth and money were not synonymous; wealth is not zero-sum, it can be created (as in business or labor) or destroyed (as in war or a hurricane). Money is simply a mechanism for quantifying the amount of wealth in circulation at any given time. In practice this can be confusing, because the money supply is always changing just like the amount of real wealth underlying it in circulation is. But in the abstract, money itself has no more relation to wealth than does the menu to the food. Not a few psychopathologies center around some form of attempting to “eat the menu”, but money is worthless until it is exchanged for some unit of wealth — services, products, land, etc. Money in the post-Medieval era is a technology for enabling the creation of new wealth by “renting out” the actual value of existing wealth that currently lays fallow. If I have a million dollars that I know I won’t need for a while, and I lend it to someone as startup capital for a business venture, and his business succeeds in creating more wealth through alchemical mixture of resources already in existence, he can return the capital to me after having genuinely enriched himself. Wealth can be enlisted to create more wealth than there already was in existence, which is to say, it has a “rental value” separate from its absolute value. The mechanism for identifying and optimizing this rental value came (clumsily) to be called “capitalism.”
Therefore, wealth currently “rented out” — i.e. held in any form other than cash — has lost its liquidity. Liquidity was effectively “exchanged” for the opportunity to become greater when re-liquidated. And ‘occupied’ wealth is necessarily worth less than wealth held purely in cash, both because money has a time value[1], and because there is never a guarantee that a ship which has left its port will come home without a hitch. Creditors default, governments and market referees sin and err, external conditions change between departure and return even if the initial terms are honored. Countless theoretical risks and sub-risks could be itemized apart from the obvious any time capital is rented out, just as a rental car can crash or an Airbnb guest can damage or reduce the entry value of a property. The present value of invested capital is assessed not by its initial amount, but a combination of its ease of re-liquidation and when/how likely that is to be possible.
The problem is that most people use the word liquidity only in its “logistical” sense, to refer to the presence or absence of a willing counter-party, independent of the price that counter-party is willing to pay. Millions of shares of Apple stock are traded every day — you will certainly find a buyer or a seller if you ever decide to take or amend a position. It is commonly said by the high frequency trading and hedge fund industries that they are “providing liquidity” through constant movement in and out of positions, in a way that evokes the glib refrain of ex-convicts claiming to have “paid their debt to society.” Liquidation is a beneficial service only if the provider pays the price of its actual value: to represent the offer to turn an asset into cash as a universal boon would be to pretend there is confirmed knowledge and universal agreement on what the true value of that asset was. The reason asset prices fluctuate in the first place is that determining the present value of future returns, much less if and when those expected returns will materialize, is far from a science (even though many economists make a living pretending it is one).
In other words, liquidity means ready availability to convert an asset back to cash at fair value, not simply at any value — or the value determined by the market at that particular moment. Highly traded stocks can easily reach double digit percentage fluctuations in one day — is there any economic possibility that a company is worth ten percent less than it was this afternoon if nothing has materially changed with the underlying business? One of the most important financial adages ever uttered was by Benjamin Graham, the first teacher of Warren Buffett: in the short term, the market is a voting machine, in the long term, a weighing machine. What he meant was that people love to debate who will win a game before it has been played, but not after. The spastic facility of entering and exiting stock positions creates wild fluctuations in valuation, the more so the farther out into the future a security’s earnings are pricing in. Over the long term, the price of a security will narrow in on its actual wealth-value. The “voting” that stock prices represent is simply an estimate about the amount of money it will deliver to its holder in the future, combined with the adjusted future value of that money (its “discounted” value). Asset prices are affected by many things besides the true discounted cash value of the sum of their future earnings — the more easily so the further into the future those future earnings are pricing in. Sexy or fast growing stocks can trade at many decades’ worth of future earnings discounted back to the present — but if the valuation is unduly optimistic, if the returns never start coming in, the fad will eventually end. With capital markets, the future always comes; the jury eventually comes in.
It is possible to see your net worth go up and down, based on the current price or “liquidation rate” of your holdings. But if you asked ten people on the street would they would pay for your home each day, would you really feel yourself ‘poorer’ on the days when the highest number was lower than the previous?
In the technical definition, real estate is far less “liquid” than stocks: any property still has to solicit a buyer, who might fail to appear any given month for no fault of the property’s own. Even a particularly good property might just take a little longer than usual to find bidders, for never explained reasons. And this is independent of the fact that you have to work through brokers, deal with bureaucracy and diligence, make tax preparations, wait for a closing, and on and on. Finding a buyer, agreeing on a price, and closing amounts to a process and a half — dizzying compared to the thirty second purchase or sale of a stock from a mobile app of an online broker. But this refers to logistics of making the transaction, not to seeing to it that the price it is executed at is a reasonable one/correlates to present value of its future cash flows. If you price a Fifth Avenue mansion at five dollars, you will have buyers banging down the doors and offering to do all the leg work for you, offer the money upfront in escrow, with guaranteed protection against bureaucratic contingency. Conversely, if the most brilliant stock analyst in the world determines the fair value of a stock, she might set a limit order with a broker that goes unfilled for years. There is never a guarantee that a buyer will offer an exit from an investment at its current actual fair price. An asset class’s liquidity quantum is necessarily pegged to it only if you’re indifferent to getting the price for something that its actually worth. If you bought at market tops in the late 1960s, even if you paid a price reasonably correlated to the amount of wealth the security was set to deliver over its lifetime, you would not have an easy time liquidating at fair value until the early 80s. Which is to say, you had to be willing to sit it out and regard the capital as ‘illiquid’ in order to get fair value for it, until a fair price buyer (the corrected market) came along.
All this is to say: real liquidity is determined by the remoteness of fair-price buyers, not simply the pool of buyers willing to pay what the stock market has priced at any given moment. Extra “liquid” assets like stocks are hardly more likely to do this on a businesslike time frame than are nominally less liquid investments; in fact, the heightened superficial liquidity tends to yield just the opposite effect: prolonged periods of unreasonable valuations.
Restricting your capital to investments that you know will continue delivering the goods only half protects you from getting burned; you must also be free from the risk of having to liquidate it before you are able to get the fair value of said goods. If you don’t have the maneuverability to leave it illiquid, you are at risk of losing money even if an investment proves to have been perfectly sound in financial terms, i.e., in the long run. The (wide) room for discrepancy between the monetary and wealth value of financial assets creates the seductive lure of easy money, as well as the principal politically and socially deleterious effects of market capitalism — which is why Warren Buffett has refused after decades to split his now six figure per share stock. But all a prudent investor needs to know is that true liquidity refers to the degree of potential deviation from genuine underlying value, not simply the availability of a buyer to unload it on, no matter how deviant it is from said value.
[1] Even if the overwhelming trend of the money supply in modern economies were not toward inflation, a dollar held today can be spent today or tomorrow; a dollar not held until tomorrow can only be spent tomorrow.
