Investors create portfolios in an effort to reduce risk and maximize income. Because they contain multiple assets, portfolios spread invested capital across those assets, potentially creating diversification. The end result is that 100% of invested capital isn’t exposed to the outcome of a single asset.
There is much that goes into creating a diversified portfolio, which we’ve previously discussed. But when analyzing a portfolio, there is one area that most investors may not be aware of — the interplay between risk and liquidity.
Defining Risk and Liquidity
Risk is an involved topic to define, so let’s start with liquidity. Liquidity is the depth of buyers and sellers at specific prices. For stocks, this is called the bid and ask spread (i.e., bid x ask). Sellers are on the bid, and buyers are on the ask. For example, a stock with the last price of 85.50 may have a bid x ask of 85.25 x 85.50. Someone wanting to buy will pay 85.50, and someone wanting to sell will get 85.25.
When liquidity begins diminishing, the bid x ask will expand as the market tries to find buyers and sellers. With an illiquid stock, the bid x ask might be 83.75 x 86.50 (a 2.75 spread). Instead of buying the stock for 85.50, it will cost 86.50.
Illiquidity makes price discovery difficult. In some cases, an investor may not know what their illiquid investment is worth until they try to sell it. Or, the investor may think the investment is worth one price only to find out they were way off at the time of sale.
Let's now revisit risk. A common measure of risk is price volatility. This is because an asset's price can swing down below the investor's cost basis. The swing's degree depends on many factors, but one factor is the amount of volatility inherent in the asset. A highly volatile asset will have larger price swings than one that is less volatile. Volatility is the definition of risk that is used in modern portfolio theory.
There are other components of risk as well, such as the company's financial condition (stock), the sector/industry that the company is part of, the overall health of the economy, or prospects of a neighborhood (real estate).
How do risk and liquidity affect a portfolio?
Opposite Sides of the Same Coin
Risk and liquidity are opposite sides of the same coin. Where you find one, you’ll find the other. Here, we’re specifically referring to volatility as risk.
To see why volatility and liquidity are interlinked, let’s look at the S&P 500 index during February and March of 2020. When the price of the index began falling, its volatility increased. As volatility increased, liquidity started drying up. As liquidity dried up, bid x ask spreads expanded. The expansion of bid x ask spreads caused the asset’s price to fall even further.
But why did those specific mechanics play out? With a low volatility asset, the price is bobbing around in more or less an orderly manner. There's no panic involved. Buying and selling are proceeding as normal. There are enough buyers and sellers near the current price that the bid x ask spread has not expanded.
Now let's say some negative news comes across the wire and people decide they don't want to hold the asset anymore. Sellers rush in, and of course, buyers fade away. As that happens, sellers overwhelm buyers. This doesn't mean more sells than buys are occurring. Buying and selling is a 1-1 relation. It does mean more investors are trying to sell than buy.
With many investors trying to sell, the asset's price will begin going lower as it seeks to find buyers. As buyers can't be found, the price continues lower. The issue is liquidity. If buyers decided to step in, the decline would slow as sellers now have the liquidity they are looking for. If buyers and sellers normalize so the number of buyers equals the number of sellers, the price will stabilize, and volatility will drop. The bid x ask spread will also decrease.
The above is the same scenario that played out during the market’s rapid March 2020 decline. The market only began to bottom and turn back up because liquidity came in with buyers equaling and then overwhelming sellers.
Volatility presents risk when it increases, and liquidity decreases. In this scenario, an asset's price can move very quickly, not allowing investors much, if any, time to react.
This risk can be managed by choosing investments that have historical low volatilities. Low volatility assets are those with a beta of less than one. A beta of less than one means the investment moves less than the overall market (i.e., S&P 500). Of course, it’s always best to work with your financial advisor when choosing investments.