Another instalment in a series of articles detailing how to design a secure, income-producing portfolio.

In my series of articles so far, we have dispelled the idea that liquidity is always and everywhere good, and we have shown that most liquid portfolios are not truly diversified. We’ve shown that liquid securities are volatile, and therefore expensive, because they have an easily accessible sell button, even as many people fail to examine liquidity’s true value-to-cost ratio. Everything we’ve come across has pointed to the idea that shrewd investors should consider diversifying beyond liquid securities.

Why, after all, should any portfolio that has a medium or long-time horizon be so heavily tilted toward assets that are easily sold? Why should endowment portfolios, which can be viewed as having an infinite time horizon, be concentrated in assets that have daily liquidity? The answer is they shouldn’t – and a financial planning tool that can be found in every investment advisor’s office has been saying as much for years, although no one’s noticed.

A key assumption of Modern Portfolio Theory is that there is some efficient frontier – that is, the optimal allocation of different assets – that offers the sweet spot of risk and return. Every financial planning shop is equipped with a computer model containing data on historic returns for different asset classes. To any given client’s specifications, the model spits out an optimal asset allocation for highest return with lowest volatility. But consider this: these computer models are almost always hard-wired to limit a portfolio’s illiquid hard assets, including real estate, to no more than 10% of total portfolio value. The fact that they’re hard-wired this way is a consequence of liquidity bias.