Liquidity is overrated. Once you have about six months worth of living expenses saved, there’s really no need to hoard even more cash since you have insurance. If you do accumulate more cash, that’s called “cash drag” because cash returns have underperformed assets such as stocks, bonds, and real estate since the beginning of our financial markets.
Once you identify a trend, your goal should be to buy assets that benefit from that trend, and hold on for as long as possible. Of course, if you think an impending bear market is on the horizon, holding more cash is good. However, over the long-term, having too much liquidity I argue is a detriment.
When I first came to San Francisco in 2001 from Manhattan, I discovered that San Francisco property was so cheap compared to Manhattan property, yet wages were quite similar. Consequently, I bought all the real estate my salary could afford in 2003, 2005, and 2014, and held on for as long as possible.
Now, I foresee a similar long-term trend happening in the heartland of America because San Francisco and other coastal cities have gotten too expensive and technology makes living in a congested area while paying $4,500/month for rent, unnecessary and obsolete. Companies located in high cost of living areas can’t comfortably afford to hire workers, and the workers can’t comfortably afford to save for retirement and raise a family.
Every single one of my biggest investment wins has occurred because I waited 10 years or longer before selling. There was only one stock that I made an enormous return in just six months, but that was dotcom bubble luck. On the other hand, there are plenty of stocks I lost tons of money on because I got shaken out way too early. If I had held on, I would have been much better off.
The Potential Benefits of Patient Capital
Patient capital is why the world’s wealthiest people and the largest institutional funds have a minority of their net worth in public investments.
They know that by removing the temptation to get in and out of investments during times of volatility, they stand a better chance to make higher returns.
Think about all the people who freaked out during the 2008-2010 crisis and sold stocks and real estate at the bottom. They are kicking themselves now for not holding on.
Further, patient capital realizes there are potential arbitrage opportunities to exploit in illiquid investments. When you don’t have the entire world competing against you, it’s much easier to find opportunities.
Let’s take a look at the latest asset allocation of the ~$30 billion Yale endowment fund, which has returned 11.8% a year for the past 20 years.
What stands out most from Yale’s asset allocation is how little there is in traditional Domestic Equity (3%) and Bonds And Cash (6.5%). 90%+ of their assets are in patient capital investments.
Their 26% asset allocation into Absolute Return are investments in hedge funds that likely have a blend of long-short equity and credit investments. However, these funds have long-term lockups as well.
Here’s an asset allocation breakdown by net worth that shows how patient capital grows with wealth. The asset that grows with wealth the most is Business Interests. While the assets that shrink the most are Primary Residence and Liquid.
In a key study 25 years ago, Michael Jensen of Harvard University argued that the tradable nature of any public corporation generates an inherent discount because of the fundamental conflict between those who bear the risk (shareholders) and those who manage the risk (executives) over the payout of free cash flow.
Jensen noted that public corporations tend to hold twice the amount of cash as private companies, which by contrast exhibit higher equity ownership by managers and more leveraged corporate structures that help limit the non-utilization of free cash flow.
Private companies were thus seen as better aligning the interests of owners and managers, and in fact appeared to Mr. Jensen to achieve “remarkable gains in operating efficiency, employee productivity, and shareholder value.”
Obviously, the poorer you are, the less you can afford to tie up your capital in patient investments. But if you want to get wealthy, your goal is to THINK and ACT like the wealthy. When I need a dose of inspiration, I go running amidst the mansions in Pacific Heights. I don’t go to the mall and splurge on things I don’t need.
When you have a lot of liquidity, financial discipline tends to get thrown out the window. The cash burns a hole in your pocket, waiting to get spent. This phenomenon is why paying yourself first is a fundamental principle behind good personal finance habits. The government pays itself first by forcing companies to deduct taxes from each paycheck because it knows there will be a huge revenue shortfall if it does not.
Without liquidity, your temptation to spend on things you don’t need goes away. The longer you can lock up your patient capital, the more time you give your investments to compound. Being able to more easily sit tight is why real estate is one of my favorite asset classes to build long-term wealth.
What is Illiquidity Worth?
One study focusing on hedge funds shows that funds with longer “lockups” (which enable managers to invest in less liquid holdings) tend to earn higher returns than those without
The data there indicated that fund returns actually rise as their lock-up period increases, from a median of 4.5% for funds with lock-ups of less than a fiscal quarter up to a median return of almost 13% for funds with a two- to three-year lock-up.
But yes, hedge fund returns overall have lagged behind the S&P 500 since the financial crisis since it’s been a bull market since.
Another study by researchers from the universities of Chicago, Virginia and Oxford showed that while venture capital results varied, U.S. buyout funds generally outperformed publicly traded equities by as much as 3% annually.
To capture some of the illiquidity premia, institutions and endowments typically hold a significant portion of their portfolio in alternative investments as we saw with the Yale endowment example.
Are individual investors missing out on the illiquidity premium? Institutional investors seem to understand this.
The Real Estate Illiquidity Premium
For the average person, real estate is the most obvious place to invest patient capital. It takes a big commitment to get in if you are buying property individually, and there are fees and taxes to pay if you want to get out. But over time, as you pay down debt and watch rents and principal grow, your equity starts to expand.
Paying down debt becomes an unconscious habit because your mortgage is on auto-deduct. Rents tend to go up over time simply due to inflation. If you can also capture principal appreciation, then I dare say you will likely return a handsome profit if you can hold on for 10+ years.
If you don’t want to own and manage your own property, then real estate finance marketplaces can help smooth the way for investors to participate in private investments that can potentially help them realize the real estate illiquidity premium.
My long-term wealth creation plan is to continue investing in real estate and building an online business. As luck would have it, both assets are synergistic because I can write about real estate.
Stocks, on the other hand, continue to create the greatest challenge for me in terms of patient capital. The slow rise and quick decimation of stocks forces me to limit my overall stock exposure to no more than 25% of my net worth.
Readers, what have been your best long-term investments? What are your favorite asset classes for patient capital?