We interviewed financial writer Morgan Housel about the problem with liquidity in the stock market.
I came across an article last month by Morgan Housel of the Collaborative Fund about the role that liquidity plays in investor decisions. Morgan wrote about investor behavior for The Motley Fool, LLC for 10 years. His current job involves private-equity investing, in addition to continuing his writing.
Private markets, generally, are not as liquid as public markets. Put more plainly, it’s harder to buy and sell “stock” in private markets. Morgan has found that to be a good thing for the most part. Here’s my favorite passage from his column.
“The only strategy I know of that truly helps everyone with poor investment behavior is taking liquidity away as an option. It’s a world I’ve seen up close in my last year working with private-market investments that have little liquidity. What do we do when we read a scary headline about a looming recession? Nothing. Because we can’t. What do we do when one of our portfolio companies misses its quarterly numbers? We try to help them, but we don’t sell. Because we can’t. How do we respond when one of our portfolio companies is crushing it? With a high five, but not much else. Because there’s not much else we can do. Which is awesome.”
Morgan still lives near Fool Funds HQ, and he was kind enough to answer a few follow-up questions for me.
How does liquidity, or lack thereof, contribute to bad investor behaviors?
Morgan: The ability to buy or sell whenever you want with hardly any cost or friction only entices you to do just that. Which can backfire, because we know the majority of investment success is merely your ability to sit still, endure volatility, and leave your portfolio mostly alone. But since we live in a world with nearly infinite liquidity, you can be on your couch, watching a pundit on CNBC who says the world is going to come to an end, and literally within 30 seconds you can sell every stock in your portfolio. Limitless liquidity means there are no speed bumps to help prevent emotion-based buy and sell decisions.
When can investment liquidity be a good thing, and when can it be a bad thing?
Morgan: It’s a wonderful thing when you need it. You need liquidity when you get into an investment, and when you get out. But that’s not that often for long-term investors. If you’re owning a stock for five or 10 years, you’ll spend 99% of your time as an investor not needing liquidity. So, look, we can’t say it’s a bad thing. It’s 100% necessary. But its ever-present nature has some downsides that get overlooked.
You say that the stock market is a place where two different games are being played. What do you mean by that? And why is it important for investors to know the difference?
Morgan: Every stock investor is playing on the same field. But some people are traders, and some are investors. Those are two very different games. Traders need liquidity all the time, because they’re buying and selling all day long. That’s their game. Investors don’t need that liquidity almost all the time. Their game is waiting. It gets dangerous when investors start taking their cues from traders.
If I’m an investor and I see a stock fall 10%, I could think to myself, “Wow, maybe other people know something I don’t. I should sell, just like them.” But the reality could be that the stock price is being moved by traders with extremely short time horizons, which may not be relevant to your goals. It’s like you’re playing football, but on the same field is a game of baseball. You’re running toward the end zone, but then you see a baseball player running in circles around the bases. You say to yourself, “Hmm, maybe he’s doing it right. Should I start running in circles, too?” Totally different games.
What are some of your takeaways from investing in private companies that could benefit stock or mutual fund investors?
Morgan: Most private-market investors have little if any liquidity. We can’t sell our investments tomorrow if we wanted to. Or next month, or this year even. We’re kind of stuck. Look, there are drawbacks to that. Our transactions, when they occur, are insanely expensive and can take months to negotiate. But the upside is that we are never, ever tempted to panic-sell, because we can’t. That alone takes one of the hardest things about investing off the table.
We have a redemption fee on our funds. We charge an extra 2% for anyone who sells our funds within 90 days of buying them. You seem to be in favor some such fees. Why is that?
Morgan: One hundred percent in favor. It’s a speed bump. And like most speed bumps they might appear annoying, but they’re quite effective at reducing harm to both you and others around you.
What other steps would you like to see to make markets more “investor-friendly”?
Morgan: It’s a hard question, for two reasons. One, we will never solve for bad investor behavior, because it’s part of human nature. Two, we don’t want to take liquidity away from investors, because it’s so integral to promoting savings and making markets work. I’m in favor of redemption fees, and even a more tiered capital-gains tax system where truly long-term investors pay a dramatically reduced rate to push more capital in that direction. But in general, this is one of those things that investors have to think about and contextualize in an attempt to better understand the world around them and understand their own propensity to respond to market moves in unhelpful ways.
I highly recommend following Morgan for his insights on markets, investor behavior and psychology, and more. You can follow him at the Collaborative Fund's blog.