The other day, I ran into an acquaintance named Billy. He likes to brag a bit and occasionally talk about things beyond the scope of his expertise.
This particular day, Billy exclaimed, “I’m holding this piece of real estate because it diversifies my portfolio and makes it less risky.”
Previously, Billy has made similar claims about precious gems, gold coins and collectible art. My guess is it will only be a matter of time before he extolls the virtues of digital art known as non-fungible tokens or NFT’s.
The belief that real estate diversifies and reduces risk is a common line of thought. However, our response is, “Really, how?”
Billy countered that real estate is not as volatile as the stock market and added that when the market plummeted due to the pandemic, this diversified his portfolio.
On the contrary, I argued the opposite. Billy wasn’t sure where I was going with this. He countered, “How can this be? My tract of land didn’t drop by 34% in March.”
How do you know? Did you try to sell your land last March? What about your collectible art, coins or gems?
Billy sheepishly said, “No,” he had not tried to market his illiquid assets any time during the last year.
More specifically, he did not call a broker and demand that his land be converted into cash by the close of business on any one particular day.
Okay. Therein lies the problem. If you don’t attempt to sell your “diversifier” asset, you have no idea how much pricing volatility you are actually incurring. If there is limited liquidity, then how does this spread out risk?
I commented to Billy that he is actually incurring more “risk” in the process of owning these types of assets.
Billy didn’t like the answer and wanted more clarification.
Whether land, art or other collectibles, they are illiquid. Furthermore, they often have holding costs for insurance, property tax, security, maintenance, etc. As such, these “diversifiers” actually produce a negative cash flow to your portfolio.
Often, we hear the same sales pitch out of investment consultants pushing a variety of private equity and hedge funds.
As we have seen recently, there is nothing special about a “hedge” fund. It rarely “hedges” anything. Rather, it is simply a fund that caters to an exclusive (although not necessarily knowledgeable) clientele.
What you really need to ask is whether you understand how the hedge fund, private equity fund or other investment partnership will invest your hard-earned money.
- From this conversation, there are a few things that Billy, and all other investors, should understand when making critical decisions with their savings.
- Just because an asset’s value is not quoted daily does not make it less risky. Rather, it simply means it is “out of sight, out of mind.” However, if you demand fast liquidity it is almost a guarantee that an illiquid asset will be even more volatile.
- Daily pricing volatility is not the same thing as risk. There is no such thing as a “one-size-fits-all” definition of risk. Rather, there are multitudes of risk weighing upon every portfolio each day. As such, you must know which types of risk are acceptable and which are not so you can build and manage your portfolio accordingly.
- Average investors would be far better off if their stocks were illiquid and rarely traded. They would think more deeply about their investments before plunging into the “deal of the day.” Tax efficiency would also improve if trading declined.
- Owning an illiquid asset without daily quotes does not necessarily diversify your portfolio. Diversification depends upon the cash flow production and business model underlying an asset. If you own a mediocre investment with poor return characteristics, then owning 10 similarly mediocre investments from differing industries or geographies does not improve your position. Focus on owning a smaller number of high-quality assets that you really understand as opposed to “lots of junk.”
- Private equity and hedge funds are just another in a long line of pooled investments with a promise of turning water into wine. There is nothing special about these pooled arrangements other than their typically high fee arrangements.