This article was originally published in June 2020.
Market volatility is at an historic extreme. From a technical perspective, post-pandemic US 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 (11 June) the US 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.