Market volatility is at an historic extreme. From a technical perspective, post-pandemic U.S. stock markets are behaving in a manner unseen in price history, making multi-year lows and highs in a matter of weeks. Liquidity comes at a price.
Read on to better understand why volatility is the price of being liquid.
The most common piece of investment advice is stay liquid. Simply put, this is the suggestion to put your wealth in investments that can be easily converted to cash, like stocks. This practically universal refrain has convinced millions of investors around the world that liquidity is inherently good. But as I’m about to show, liquidity isn’t good. Nor is it bad. .
Liquidity is neither good nor bad, it is cheap or expensive. And right now, it’s very expensive.
During normal market activity, liquidity is cheap. By “cheap” I mean that selling a liquid asset has only an imperceptible impact on its price. In fact, in a rising market, if you sell a stock that’s listed at $35.25, the price you receive may even be a little higher higher—say, $35.50—because there is excess demand for that particular stock relative to supply.
But, as we’ve seen, a major event moves a critical mass of investors and they all decide to sell (or buy) at the same time. When they sell, prices go into freefall. Last week (11Jun) the U.S. and other major global markets fell 5 to 7% in one day. These declines are naturally scary. But it gets worse because volatility “clusters.” This means that volatility is often condensed in time and if last week was choppy, the best prediction is that next week will also be choppy… until it’s not. This one statement – “volatiltity clusters” – puts the lie to portfolio diversification in liquid markets. Because, when you need diversification most, everything moves together and it moves fast.
As markets sell off, perhaps you tell yourself that you won’t sell, but as you watch those numbers go down, you become too scared to hold, and you jump into the fray: You want to pull out your cash because that will make you feel safe.
In this situation, when your sell order overlaps with so many other market participants’ orders to do the same thing at the same time, you can get your money out—but you sure won’t like the price. This is the cost of staying liquid, and in moments like today, liquidity is expensive.
It’s important to note that this cost is the direct result of the volatility of liquid markets. Volatility goes hand in hand with liquidity; they are two sides of the same coin. Why? Because by definition liquid assets feature an easily accessible sell button. Anyone and everyone can choose to sell, all at the same time, and that produces the wild ride of the markets.
There’s actually an easy and fascinating way to see how liquidity produces volatility: by looking at price data for publicly traded real estate investment trusts, or REITs. These securities contain income-producing real estate, and some of them are traded on the NYSE. During the financial crisis, from their peak in 2008 to trough in 2009, REITs fell almost 80 percent. But how much did the values of the underlying assets—the real estate itself—drop over the same period? Depending on which index you looked at, the decline in the actual real estate was 20 to 40 percent. Shares of REITs and the real estate contained in those REITs are supposed to be the same asset. They are supposed to be the very same investment. Yet the one with the accessible sell button evidences two to four times the volatility of the other. In other words: liquidity begets volatility.