Friday, December 16, 2005

 

Who needs liquidity?

Although my portfolio declined about $1,300 today, I finished the week up $5,565 (0.9 percent), slightly better than the S&P 500 (up 0.6 percent), but considerably better than the NASDAQ (down 0.2 percent) and Russell 2000 (down 0.8 percent). This is also the first week that my portfolio has closed above the $600 K level.

Occasionally I get emails that mention that my style of investing suffers from a major problem: I tend to invest in very illiquid stocks, which implies that if the market tumbles, I would have difficulty liquidating my positions.

I must admit, I don't quite buy this argument. First of all, I am not sure why I would want to liquidate my positions if the market tumbles (wouldn't my shares be cheaper and more undervalued then?). The liquidity argument is perfectly valid for daytraders and market-timers, but I'm neither. Second, even though I do invest in illiquid stocks, they are not that illiquid. Although it's true that sometimes it takes me days if not weeks to build a position, that's largely because I tend to set limit orders at or below the bid price, hoping that someone will catch the bait. Third, illiquidity can be a good thing since it often spawns volatility, and volatility allows you to buy low when the stock is temporarily depressed and sell high when the stock temporarily surges. As long as you have a well diversified portfolio (as I do), volatility is nothing to fear. Fourth, there is a substantial academic literature showing that over time, the rate of appreciation of illiquid stocks exceeds those of their liquid cousins. This is true even if one conditions on market capitalization, so this premium exists above and beyond the familiar premium that the market rewards to small cap stocks. As always, your comments on my observations are very welcome.

Comments:
Thanks for the link to interesting article. No doubt that illiquid stocks are priced with a discount.
However, who can count a lost trading profit from sitting dumb in illquid position for weeks or months. Seems to me, the winning portfolio should be diversified not only by sectors or market capitalization but by liquidity too. You should have both liquid and low liquid stocks and it will give you flexibility and chance for making trading profits in any time, plus being comfortable with fundamentally strong stocks
 
Well, "more undervalued" assumes that the earnings of the company in question are static. What if they go down, and it's illiquid?

As far as being diversified, what if the earnings of all go down? That's what happens at the onset of a recession.

Nevertheless, if your record is as portrayed on the site, there is no arguing with success.

Would like to see your number of shares in each holding, as well as cash.
 
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