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Beware of the curse of liquidity

Shares are an excellent long-term investment, but the ease with which they can be bought and sold can be both a blessing and a curse. Just because you can, doesn’t mean you should.

Stock markets have been bouncing around recently, as conflicting reports arrive about the situation in Ukraine and the effect of possible sanctions. The optimists are seeing any dip in the market as a great opportunity to jump in and buy, while the most extreme of the pessimists are forecasting we are on the brink of another major war.

Having observed the behaviour of markets for more than 50 years, I’ve long given up making forecasts. There has never been a time when the pessimists weren’t with us, but most of them remind me of a stopped clock – right twice a day.

I will certainly be looking at buying opportunities if the market falls, but it is vital for anybody considering investing in shares to understand that volatility is the price we pay for liquidity. Only shares offer the opportunity to buy and sell in small parcels with minimal cost, and have the proceeds in your bank account in five days.

To help individuals understand the way stock markets work, investment guru Warren Buffett used his recent annual newsletter to tell the story of a farm he has owned since 1986. Unless you are a short term trader, in other words a gambler, Buffett believes you should treat your share portfolio in exactly the same way as you would your real estate investments.

“Those people who can sit quietly for decades when they own a farm or apartment too often become frenetic when they are exposed to a string of stock quotations,” Buffett said. “For these investors, liquidity is transferred from the unqualified benefit it should be, to a curse.” He argues that the goal of the ordinary investor should not be to pick winners: they should simply hold a diversified portfolio and stick with it.

Buffett compared the fluctuations in the share market as akin to an erratic neighbour leaning over the fence screaming out offers for his land every day.

“Imagine a moody fellow with a farm bordering on my property who yelled out a price every day at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state. If his bid today was ridiculously low, I could buy his farm … if it was ridiculously high I could either sell to him or just go on farming.”

Let’s translate that to our local market. Let’s say you owned a blue chip share XYZ Limited that was selling at $40. The company is highly profitable, paying increasing dividends, is well managed, and is a market leader. Suddenly, due to the possibility of war in Ukraine, Wall Street tumbles, traders all around the world panic and sell, and our market drops 3%. Of course, shares in XYZ will fall too, and you may wake up to find your $40 share is now worth $39.

As far as XYZ is concerned, nothing has changed. The business is as strong as ever, and 99.5% of investors are happy to sit tight and enjoy the growing income stream. Only a desperate few panic and sell and take a loss, just because the market in general reacted to events that happened thousands of miles away.

No investment offers the growth potential, ease of ownership, or tax concessions of shares. Buffett’s phrase ‘the curse of liquidity’ is a new one to me, but it sums up markets perfectly. Every investment decision you make will have advantages and disadvantages. The downside of liquidity is that you can be tempted to sell just because you can.

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This content is provided by Cuffelinks and does not represent the views of AMP Capital.

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