There are many different types of investments available on the market, and each one comes with its own set of pros and cons. One type of investment that often gets overlooked is an illiquid investment. So what are illiquid investments? And which investment has the least liquidity?
In this article, we will take a look at what is an illiquid investment and both the pros and cons of investing in an asset that has low liquidity.
What is an illiquid investment?
An illiquid investment is not easily converted into cash. This can be a disadvantage because it can be difficult to sell these investments when you need to access the funds. However, there are also some advantages to investing in illiquid assets.
What types of investments are not liquid?
The types of investments that are not liquid are investments such as real estate, hedge funds, venture capital, fine art/collectibles, and private equity. These assets are not easy to sell because there is often a lack of buyers willing to pay the same price for the asset.
This can be a problem if you need to access the funds quickly. However, these types of investments often have the potential to earn a higher return than more liquid investments.
There are pros and cons to the liquidity factor of each option, let's explore them in more detail.
Real estate
Real estate is the most well-known illiquid investment. It can take months, or even years, to sell a property. And that's only if you find a buyer who is willing to pay the asking price. If interest rates are high, it can be even more difficult to sell a property.
An increase in crime rates, closure of nearby job markets, and other reasons can also make it difficult to find a buyer. These assets aren't cheap when compared to other options and they can quickly turn into a liability that is difficult to get rid of.
Advantages of investing in real estate
The main advantage of investing in real estate is that it has the potential to earn a high return on investment. This is because real estate prices often increase over time. If your rents are higher than the mortgage payments, they can also provide a steady income stream.
Another advantage of real estate investing is that you can get involved in the property market without having to put down a large amount of money. You can buy a property with a small down payment and use OPM (other people's money) to fund the rest of the investment.
The illiquidity of real estate also presents an opportunity. If you are able to find properties that the owners are trying to sell fast, you can take advantage by offering a quick deal in return for a lower price. This allows real estate investors to buy properties under market value, as long as they can find these types of situations. It is fairly easy to find these types of real estate deals in remote locations that do not get a lot of attention from major real estate investors.
Disadvantages of investing in real estate
The biggest disadvantage of investing in real estate is the illiquidity. If you have a significant amount of your wealth tied up in real estate, it can be difficult to access the funds when you need them.
This can be a problem if you encounter a financial emergency or want to take advantage of an opportunity that requires a quick infusion of cash.
The other disadvantage of real estate is that it is a time-consuming investment. You will need to manage the property, find tenants, and deal with repairs and maintenance issues. With this in mind, the illiquidity of this asset can become both a financial liability and a mental burden.
Hedge funds
Hedge funds are another type of investment that is not liquid. These are private investment vehicles that are only available to accredited investors. Hedge funds are often used to invest in illiquid assets such as real estate, private equity, and venture capital.
The reason why this investment option is illiquid is that there is typically a lock-up period. This lock-up period is necessary for fund managers because it takes time to generate returns from these types of investments. If investors were constantly moving their money in and out of these funds, it can ruin their overall strategy.
Advantages of hedge funds
The main advantage of investing in hedge funds is that it can provide access to returns that are not available through traditional investment vehicles. Hedge fund managers often have a high degree of flexibility when it comes to investing. This allows them to take advantage of opportunities that other investors are not able to access.
Another advantage of the illiquidity factor of hedge funds is that investors don't have to worry about whether they should or shouldn't sell their assets. Because it is locked up, they don't have to make that decision. This can help to remove the emotional aspect of investing, which can help achieve long-term success.
Disadvantages of hedge funds
The main disadvantage of investing in hedge funds is the high fees that are charged. Hedge fund managers typically charge a management fee as well as a performance fee. The management fee is a yearly charge that covers the fund's operating expenses.
The performance fee is a percentage of the returns that are generated. This fee structure can eat into your investment returns, especially in a down market.
Another disadvantage of hedge funds is the lack of transparency. Because these are private investment vehicles, there is often little to no information available about the investments that are being made.
This can make it difficult to understand what you are actually investing in. With a lack of liquidity, it can be worrisome to know that some managers can take high risks without you even knowing or being able to take some money off the table.
Venture capital
VCs are long-term investors in startup companies and small businesses with high growth potential. They provide capital in exchange for an equity stake in the company. VCs typically invest in companies that are too risky for traditional lenders or public markets.
The reason why venture capital is an illiquid investment is that it is not easy to sell your stake in a privately-held company. There is often no secondary market for venture capital investments. This means that you are stuck with your investment until the company either goes public or is acquired by another company.
Advantages of venture capital
The main advantage of investing in venture capital is the potential for high returns. Because VCs are investing in risky companies, they have the potential to make a lot of money if the company is successful.
Another advantage of venture capital is that you can often get involved with the company that you are investing in. This can give you a chance to help shape the direction of the company and see it grow from the ground up.
These early-stage companies are often faced with many challenges. Being illiquid helps investors stay the course, even when things are tough.
Disadvantages of venture capital
The main disadvantage of investing in venture capital is the high risk. These companies are often unproven and have a higher chance of failure. This means that you could lose all of your investment if the company goes under.
Another disadvantage of venture capital is the lack of liquidity. As mentioned before, there is often no secondary market for VC investments. This means that you are stuck with your investment until the company either goes public or is acquired by another company. This can take years, and in some cases, decades. This can tie up a lot of capital that you may need access to in the meantime.
Fine art and collectibles
Fine art and collectibles are physical items that can be used for both investment and enjoyment. These can include paintings, sculptures, wine, cars, and more. Their value comes from both their rarity and their aesthetic appeal.
The reason why fine art and collectibles are illiquid investments is that it can take a long time to find a buyer willing to pay the price that you want. There is no legal requirement to lock up your investment but if there are no buyers, there is no way to cash out.
Some markets may be more liquid than others. For example, vintage cars might be more liquid than other types of collectibles because the community is more established and has more interest.
Advantages of fine art and collectibles
The main advantage of investing in fine art and collectibles is the potential for high returns. Because these items are often rare, their value can increase over time. This makes them a good investment for those looking to sell in the future.
Another advantage of investing in fine art and collectibles is the enjoyment that you can get from them. These items can be displayed and enjoyed in your home or office. They can also be used as a conversation starter when guests come over. It can also help you connect with other like-minded collectors.
Strong networks are an asset that is often underrated. As an illiquid asset, having to hold onto the item for longer than you might have anticipated can help build your reputation as a supporter of the industry rather than a fair-weather investor.
Disadvantages of fine art and collectibles
The main disadvantage of investing in fine art and collectibles is the high cost. These items can be very expensive, and there is no guarantee that they will increase in value. In fact, some items may decrease in value over time. The lack of liquidity is also a major disadvantage. As mentioned before, it can take a long time to find a buyer for an illiquid investment.
This can be frustrating and cause you to miss out on opportunities. And if you do find a buyer, fees from brokers and other middlemen can eat into your profits.
If the market is illiquid at the time, they can also offer a low price for your investment, which can be disappointing.
Private equity
Similar to venture capital, private equity is an investment in a company that is not publicly traded. This means that the only way to get your money out is to find another buyer willing to pay the price you want or wait for the company to go public.
The main difference between venture capital and private equity is that private equity is usually invested in more established companies. This means that there is less risk but also less potential for high returns.
Advantages of private equity
The main advantage of private equity is that it can provide a steadier return than other more volatile investments. It is also less risky than investing in early-stage companies.
That lack of liquidity can help investors reshape the company and stick with their investment thesis through difficult times. As an entity with a vested interest, they can make decisions that are in the long-term best interest of the company, rather than being forced to sell at a loss during down rounds.
Disadvantages of private equity
On the flip side, the main disadvantage of private equity is also illiquidity. These companies aren't publicly traded. Private equity funds can't just sell their shares on the stock market. This can be a problem if other opportunities come up or if the original investment thesis doesn't play out.
Advantages of illiquid investments
Now that we've identified some of the different types of illiquid investments, let's explore the overall advantages of illiquidity. The main advantage is that if you buy into a great asset, the illiquidity will force you to reap the long-term rewards, rather than simply flipping it for a quick profit.
For example, illiquid assets can often cause emotional stress because some traders worry about if or when they will be able to exit the position. This can lead to poorer decision-making and even panic selling in some cases.
Another advantage is that you may be able to negotiate a better price for an asset when fewer buyers are competing for it. Being able to structure a deal that meets your specific needs can also be easier when there's less interest from other parties.
Finally, the advantage of illiquidity is that it helps develop delayed gratification and a long time horizon. These are two important qualities for any investor to have. By being in a position where it doesn't make sense to consider selling for years, you're forced to think about the long-term potential of an investment. This can help you develop a more patient and rational approach to investing.
Disadvantages of illiquid investments
There are some clear disadvantages to investing in illiquid assets as well. The most obvious one is that you may not be able to sell the investment when you want or need to. This can create problems if you encounter financial difficulties and need to access your money quickly.
For example, if your car breaks down and you need to come up with $2000 for repairs, you're not going to be able to sell your stake in a startup company for that amount of cash. This can lead to alternative options such as predatory loans.
If the investment does not play out as you hoped, you might find yourself in a debt spiral. Another disadvantage is that you may not be able to get out of an investment even if it's losing money.
This can be painful to watch as you slowly notice your investment thesis falling apart. A lack of liquidity can be costly. It can also tie up a large amount of your capital in a single investment, which could limit your overall diversification and increase your risk.
For example, if your first investment was in real estate, 100% of your invested capital would be illiquid. This would be a very risky position to be in.
Conclusion
So, there you have it! Five illiquid investment types come with pros and cons. As you can see, each has its own advantages and disadvantages that you should take into account before making any decisions. Illiquidity for one asset might not be a bad thing while it can be for another. It all depends on your specific goals and circumstances.
Overall, whether or not investing in illiquid assets is right for you will come down to your individual circumstances and goals. If you're patient and have a long time horizon, the advantages may outweigh the disadvantages. However, if you need quick access to your money or are risk-averse, it may be better to stick with liquid investments.
Some assets are meant to be held onto forever. It can be a benefit for generational wealth if it's a supreme asset. Real estate, for example, can appreciate in value over time and be passed on to future generations. If you have the liquidity from other sources of income to weather any storms, holding onto illiquid assets can be a sound strategy.