We can distinguish between two types of investments: liquid investments and illiquid investments. An example of a liquid investment would be the online purchase of a stock. If you change your mind two seconds after making the purchase, you can sell the stock at virtually no cost. An example of an illiquid investment would be the construction of a new production line in a factory. If you–the CEO or business owner–change your outlook after the new line has been built, you can’t easily turn around and sell it to someone else. The engineering and labor costs are unrecoverable, and the scrap prices that you will get for whatever materials you used will be a fraction of what you paid.
A mistake that fundamentally-oriented stock market investors sometimes make is to assume that liquid and illiquid investment decisions are governed by the same considerations. They are not. Liquidity in an investment is an enormously powerful feature. In addition to having significant economic (option) and psychological (comfort) value in itself, its presence radically changes the way in which investors evaluate their investments, as well as the mode in which they receive their returns.
In an illiquid investment, all of the return comes from the payout of the underlying cash flows, over decades of time. And so evaluating the attractiveness of the investment is straightforward. Project out the cash flows, and discount them–for risk and uncertainty, the cost of money, and the cost of illiquidity, which is not small.
In a liquid investment, the cost of illiquidity is extremely small (only the bid-ask spread and transaction costs). The majority of the return comes not from payout of the underlying cash flows, but from the ability to sell the investment to others. For this reason, the piece of information that really matters, that effectively decides the outcome, is the market price: what others offer to pay for the investment in the future.
Some investors will claim that their time horizon is forever, and that they don’t care about the market prices of their investments. If they make this claim, ignore them; they are bullshitting. They definitely care. When the prices of securities they own rise rather than fall, you will not hear them talking about “infinite time horizons.” You will hear them touting their investment process, celebrating their “return”, which they consider to be very real.
In the paragraphs and posts that follow, I am going to explore the different considerations that pertain to liquid and illiquid investments, and present a general framework for how we should think about each type–with a particular emphasis on how to think about liquid investments in a stock market.
A Simplified, Easy-To-Understand Model
As always, we begin with a simplified, easy-to-understand model. We will use this model to help clarify the true, illiquid value of assets, as well as the importance of liquidity preference as a determinant of the price that will be paid to invest in them. Try, if you can, to think about the model as if you were really in it, right now, making the decisions that each person has to make. You will see first-hand how impactful considerations about liquidity are.
Suppose that you, John and Laura are investors in a closed market. This market contains three types of assets: stocks of different companies securitized into an index ($SPY), government bonds similarly securitized ($TSY), and cash.
There are 90 oustanding shares of $SPY, 90 outstanding shares of $TSY, and $9,000 of cash. That is the universe of existing assets. At present, each share of $SPY earns $6 a year in profit from the underlying companies, with the earnings growing over the long term at roughly the rate of inflation, which we will assume is around 2%. The earnings grow only at that rate because there is no internal reinvestment; 100% of the earnings are paid out as a dividend each year. Each share of $TSY pays out a constant $4 of cash per year in interest, and will mature in 10 years, at which point each share will be exchanged for $100 in cash. The $9,000 of cash is just money: dollars held electronically in a bank account. Currently, for each dollar that is not used to make purchases, the bank pays out 1 penny of interest per year, in compensation for the ability to lend it to others. This interest rate is set by the government, and changes based on the government’s management of economic conditions.
Because you, John and Laura are the only individuals in this market, one of you must hold each outstanding unit of each asset class at all times: each share of $SPY, each share of $TSY, and each dollar bill (or byte). We call this rule the “Hold Rule.” There are no exceptions to it. If no one wants to hold a give unit of an asset, the “price” of that asset, expressed in terms of other assets, will fall, until someone emerges that does want to hold it.
Suppose that you, John and Laura come into existence with the assets distributed equally, so that each of one of you owns 30 shares of $SPY, 30 shares of $TSY, and $3,000. This distribution satisfies the “Hold Rule”, because the sum of what each of you is holding equals the total outstanding quantity of each asset. But this randomly chosen distribution is unlikely to satisfy your various preferences. So I am going to “open the market.” That is, I am going to give you the opportunity to trade the assets freely among yourselves, at whatever exchange rates you choose.
The million-dollar question is, once the market is opened, what will the exchange rates between the assets be? How many dollars for each share of $SPY? How many dollars for each share of $TSY? And if shares of $SPY and $TSY can be swapped directly, without going through the medium of cash, what will the ratio between them be?
Illiquid Investment: No Uncertainty, No Trading
To get a better picture of the true, fundamental value of each asset, we need to eliminate trading, wherein an investor can generate large returns by correctly anticipating the changing preferences of others, rather than by collecting the cash flows of the asset itself. So let’s assume that the market will remain open for only one day. On that day, you, John and Laura will be able to freely conduct exchanges in accordance with your preferences. Once the day is over, the market will close forever, and the three of you will have to stick with whatever you have. Whoever is holding shares of $SPY will have to stick with those shares, forever. Whoever is holding shares of $TSY will have to stick with those shares for the next 10 years, at which point each share will be redeemed for $100 of cash that will have to be held forever. Whoever is holding cash will not be able to hold any of the other assets, but will have the ability to use the cash to purchase goods and services at any time. In theory, the person holding cash would have the ability to use it to create a new asset, but to be fair to the other asset classes, we will consider this “real investment” to be a type of trading, and assume it is not a viable option.
If you, John and Laura are perfectly rational agents, then 3 questions will determine the relative rates at which you will offer to exchange the assets. These 3 questions are:
(1) What will the future $SPY payouts be?
(2) What will the future interest rate on cash be?
(3) What is your liquidity preference? How important or valuable to you–both economically and psychologically–is the ability to have and spend your money now, versus later? What is the cost to you–again, both economically and psychologically–of having to separate with your money, not be able to touch it, for long periods of time? As an investor, what is your time horizon?
Unlike question (3), questions (1) and (2) are outside of your control. In the present scenario, we are going to eliminate them. Suppose, then, that I tell you exactly what the future payouts of $SPY will be, and exactly what the interest rate on cash will be, in each future year up to eternity. Because we’ve eliminated the ability to make money by trading, you will know everything there is to know about the returns offered by each asset class. Those returns are shown in the table below:
As we see from the table, the advantage of $SPY relative to cash is that it will pay out more over time. $TSY also has this advantage, but the advantage is lessened by the fact that the payouts do not grow with inflation, and also by the fact that the fund matures into cash in 10 years.
The disadvantage of $SPY relative to cash is that you will have to wait to get the money. If you exchange $100 of cash for $SPY, it will take you 14 years to get that amount of cash back (by then, you will have $100, plus your shares of $SPY). In the interim, you will only be able to spend what you have accrued. $TSY carries this same disadvantage relative to cash, but the disadvantage is reduced by the fact that there is a maturity date, a time at which a lump sum of cash will be paid to close out the fund.
Think about the scenario in real terms, as if you actually had to make the investment choice right now. From the initial distribution, you have $3,000 of cash, 30 shares of $SPY, and 30 shares of $TSY. You can trade any of these assets for any other asset, at whatever ratio you choose. The only catch is that John and Laura–the individuals with whom you will be making the exchange–have to agree to the ratio for a trade to be carried out.
Suppose that John makes the first offer. He has a very long investment time horizon, and doesn’t need the cash. To get the highest long-term return, he wants to acquire shares of $SPY. So he offers to exchange $100 of cash for each $SPY share. He says “Look guys, I’m offering 15 times earnings, that’s a very fair price.” Would you take his offer, and sell your shares? If not $100, then what would your minimum price be? $150? $200? $300?
Let’s assume that, like John, you and Laura both have very long investment time horizons. Whatever wealth you have, you plan to put it aside and not spend it for decades. If that’s the case, then the eventual price in cash that each of you will end up offering to pay for each other’s shares of $SPY will be much higher than $100–maybe $150, or $200, or $300.
These prices would represent price-earnings (P/E) ratios of 25, 33.3 and 50 times earnings respectively–quite expensive relative to what most of us are used to. But it doesn’t matter. There is no rule written into markets that says that the P/E ratio must equal some number. The only rule is the “Hold Rule”–the rule that each unit of each asset in existence must be willingly held by someone at all times. If each of you wants to hold $SPY, and none of you wants to hold cash, then the exchange rate between $SPY and cash will rise until one of you changes your mind. Period. The same is true of $TSY. The only difference is that there is a limit to the price that an investment in $TSY can rationally command. In our example, if, to hold $TSY, you pay more in cash than $145.98–that is, $100 of principal plus $40 of collected coupon payments compounded for the relevant period of time at the cash interest rate–then you will have essentially given away your money to someone else for free.
Ultimately, $SPY and $TSY are a type of cash–with the access delayed over time, in accordance with the intervals specified in the table. And so if you think about the dynamics of the decision in front of you, you will see that everything comes down to that same question: what is the difference in value, for you, between “cash now” and “cash later”? What is your liquidity preference? If the three of you perceive there to be no difference whatsoever between the value of cash now and the value of cash 10 years from now–if having the actual money in your hand, being able to spend it whenever you want over the next 10 years, is worth zero to you–then the maximum amount of cash that you will be willing to exchange to hold $TSY will approach $145.98, an excess return of zero. And if the three of you perceive there to be no difference whatsoever between the value of cash now and the value of cash in a million years, then, assuming low and stable cash interest rates in the interim, the amount of cash (or $TSY, if you exchange the security directly) that you will be willing to exchange for $SPY will approach some absurdly high number.
Being willing to pay enormous amounts for $SPY might sound crazy, but it makes perfect sense, provided that you have a long enough time horizon. Even if you pay $1,000 a share, there will come a time when your investment will have produced more than that amount, and, assuming low and stable cash interest rates, more than cash or $TSY will have produced. The only question is whether it’s worth it to you to wait that long. For most of us, it isn’t.
Illiquid Investment: Add Uncertainty
It is common for economists to speak of a “risk premium”–a premium, in added return, that the holder of an asset with uncertain cash flows (such as equity in a company) demands in exchange for holding it, as opposed to holding a guaranteed asset. In the first scenario, no risk premia were necessary, because we disclosed the future cash flows of each asset out to eternity. In this scenario, we will reintroduce uncertainty to see how the problem changes. What we will see is that because we are utilizing indexing, the problem doesn’t change much at all.
Before we begin, let’s ask the question, why does uncertainty even require a risk premium? For each investment, there is an expected (or mean) return. The uncertainty around that return applies in both directions–to the upside and downside–therefore it doesn’t change the mean. So why should we consider the uncertainty to be a net negative that requires compensation?
The answer lies in the disparate way that the human mind evaluates profits and losses of the same magnitude. They are not the same, and they do not cancel each other out. To illustrate, suppose that there is a company that has a 50/50 chance of generating a $150 total profit, or a $50 total profit, tomorrow, after which it will dissolve. Mathematically, the expected (or mean) return of an equity investment in the company (+$150, +$50) is $100. Even though the expected return is $100, investors are not going to pay $100 in exchange for the equity. The reason is that the prospect of a $50 gain is not commensurate with the prospect of a $50 loss. Investors are, on average, risk-averse. The cost of a loss is perceived to be greater than the benefit of an equally-sized gain, and therefore investors demand to receive compensation over and above the expected return on the investment. That compensation is the risk premium–the compensation for taking the risk, which could be avoided altogether. For a given expected return, the greater magnitude and probability of the potential loss, the greater the risk premium needs to be.
To test this out in your mind, consider the following proposition. I’m going to flip a coin. If it comes out heads, I will pay you X dollars. If it comes out tails, you will pay me X dollars. Would you accept the offer? The expected return of the offer is 0, which is exactly what I am you charging to take it. So will you take it?
Granted, if X is really small, like a few dimes or pennies, you might take it. Gamble a bit, for fun. On the scale of extremely small potential losses, human risk-aversion approaches zero, and the rewards of excitement, humor and leisure can outweigh it.
However, as the amount of money that can be lost grows, the risk-aversion grows–in non-linear fashion. To illustrate, suppose that X equals your entire net worth. If heads, you double your net worth, if tails, you lose your net worth. Would you accept the offer? Of course not.
To get you to accept the possibility of losing everything that you own, I would have to compensate you by dramatically skewing the expected return–with the extremity of the skew determined by how much the loss of your net worth would hurt right now. Depending on your personality traits and life situation, I might have to offer to pay you as much as, say, 10 times your net worth if you win the flip. But even 10 to 1–an expected return equal to 9 times what you are putting at risk–might not be enough. When your net worth is at stake, we could very well be at a singularity, where no expected return, no matter how large, is worth a 50% chance of losing everything that you own.
Obviously, with respect to an individual company, there is significant uncertainty around the outcome. The cash flows that the company ends up producing could fall dramatically below the expectation. Worse yet, the company could go bankrupt, disappear forever, creating a permanent loss of capital. Subjecting one’s wealth to that uncertainty demands compensation.
But in our scenario, we are not contemplating an investment in an individual company. Rather, we are contemplating an investment in a collection of thousands of companies pooled together. When pooled together, the winners among the companies cancel out the losers. The result is a much tighter distribution around the expected outcome, and therefore a much smaller required risk premium.
In the case of $SPY, we can be reasonably confident, based on history, that next year the asset will produce something close to what it produced this year–$6. We can also be reasonably confident that the $6 will grow over time, at about the nominal growth rate of the economy. There will be expansions and recessions in which earnings will rise and fall around the trend, and so a risk premium is still necessary, but there is no reason why it needs to be particularly large. As a consideration in the problem, it is going to be dwarfed by the far more important consideration of liquidity preference.
To capture the point intuitively, put yourself back in the scenario, except without the table that tells you what $SPY’s returns will be. You know that $SPY is currently paying out $6, but you don’t know for sure what it will pay out in the future. John offers to sell you $SPY for $150. Based on your estimates, the payback will be roughly 20 years. But you can’t be sure of that estimate. Depending on how the economy performs, the payout could be 15 years, or it could be 25 years. How much does this uncertainty dissuade you from the investment? Probably not much at all. The key consideration for you, far more important than the uncertainty around the trend in $SPY’s payout, is your liquidity preference, the difference in value for you, economically and psychologically, between having cash now and having cash in the future. Ultimately, it is that preference that will make the difference in determining the maximum price that you will offer to pay.
Liquid Investment: Enter the World of the Stock Market
What we have in our first two scenarios, where you, John, and Laura must decide who will hold a set of outstanding equity, fixed income, and cash assets over the long-term, is a nice, neat problem that we can solve rationally with only two pieces of information: (1) the total future cash flow that each asset will deliver, and (2) each investor’s liquidity preference, i.e., the cost to each investor–both economically and psychologically–of parting with money, not having it or being able to use it, for extended periods of time.
Now, let’s remove the artificial constraint that the market will close forever tomorrow, and that each individual will have to stick with whatever she chooses to hold. Assume that assets can be freely exchanged indefinitely, and that cash, in addition to being spent on goods and services, can be used to create new assets.
Unfortunately, this new formulation radically changes the dynamic of the problem. Because we’ve introduced the concept of trading in a secondary market, the problem is now recursive. With respect to (1) above, the total future cash flow that the asset will deliver to the owner is no longer just a function of what the asset will earn or generate in its own operation. It is now a function of what the asset can be sold to others for. With respect to (2), the consideration that encapsulates the true cost of the investment in terms of lost liquidity is no longer the maturity or payback period of the asset, but rather, the future willingness of others to purchase the investment from the owner, should the owner want to sell it. Each investment becomes fully liquid as if it were cash, except that its value fluctuates every day based on how eager others are to own it. If you choose to get out of the investment, you will have to expose yourself to that fluctuation, which is a net negative to the proposition, given risk-aversion.
It is extremely difficult, if not impossible, to try to logically model how these considerations should interact to determine the price of an asset. If I don’t plan on holding the asset until maturity, and generating a return from its cash flows directly, I can’t know, with precision, what the highest price I should be willing to pay for the asset is, unless I know what price others will be willing to pay, at various points in the future. But I can’t know what price others will be willing to pay, at various points in the future, unless I know what price those others think yet others–to include me!–will be willing to pay, at various points farther out into the future.
The logical intractability is made worse by recursion inside the individual: what George Soros calls reflexivity. The prices that the investments are trading at are displayed on a “tape”, for all to see. The investors’ views about the investments determine those prices, but those prices also determine the investors’ views about the investments.
Each investor is a human being with insecurities. Whatever he might proudly say, his views are influenced by the aggregate views of others–which is what the “tape” expresses to him, the collective wisdom of his peers. The tape can make him scared, cautious, greedy, confident, impulsive, excited, elated, bored–emotions that have the power to alter his investment time horizon, his tolerance for risk and uncertainty, his assessment of the underlying merits of his positions, and his sense of how well those positions will perform. The result is a pricing mechanism that exhibits both momentum and path dependence. Past prices can influence future prices, and securities with the same fundamentals can easily arrive at disparate prices, depending on the paths they take to get there.
Because a liquid market functions in this way, the insights that matter are not insights about what is worth what, or what is “cheap”, or what is “expensive”, or what my “discounted cash flow model” says, based on information already given or information about to arrive. The insights that matter are insights about what other people are going to choose to do in the presence of that information. What other people will do in the face of whatever path reality takes is what decides returns, and is therefore what investors in liquid markets should be trying to understand and model. Anything that cannot in some way be related to that question is a distraction, an attempt to treat liquid investing as if it followed the radically different rules of the illiquid.
In the next piece, we will use insights gained here to refute the popular “Fed Model” for equity investing, which evaluates the attractiveness of the stock market as an investment based on how its earnings yield compares with long-term bond yields.