January 2024
Illiquidity can be nerve-wracking due to the emotional bond people have with their money and the comfort that comes from having easy access to it. Stacey discusses conversations she has with clients about balancing liquid assets for immediate needs versus investing in long-term illiquid assets like businesses or real estate, which may offer better returns but less accessibility. Different account types, cash flow needs, and individual circumstances have a huge impact on which illiquid investments one should acquire and how much of one’s portfolio should be made of illiquid investments.
It is critical to take a balanced approach to liquidity in financial planning, and investors should consider having different “buckets” of assets categorized by their liquidity needs to meet various goals.
Watch previous episodes here:
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Ep. 67 Generating Income by Lending on Real Estate
Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, joined by Chief Operating Officer Stacey McKinnon. Stacey, thank you for joining us.
Happy to be here.
I'm excited about this conversation. Liquidity or illiquidity. What we mean by that is having money in an investment that you can't click a couple of buttons and get access to it within a couple of days. And it tends to be a very sensitive topic around people because money has a whole lot of emotions that come with it, right?
And so having access to our money is something that helps us sleep at night and helps us feel comfortable. And so the term illiquidity can be a little bit nerve wracking sometimes.
Yeah, I'm excited to talk about this because it's a conversation we're constantly having with our clients. The question around like, how much money do you need to have on hand and how much money can we invest for the long term and the kind of things that we feel around that sometimes feel complicated for a lot of clients, where having all of your money accessible might feel good in the short run, but probably isn't the best investment strategy in the long run.
And the account type matters a lot too. I mean, we'll get into that a little bit, but I love your points in the sense that, you know, when I even reflect back on myself or even clients, it's easy to look back when you're young in your career and you're saving or if you're, you know, older and you put kids through college and now you're looking for retirement or you're, you know, nearing the end of retirement and you're saying, I don't know if I'm going to be around for another ten years.
So it doesn't make sense to go make that investment. Oftentimes you look back and it's like, well, no, I could have taken on that illiquid investment. I could have purchased that piece of real estate. You know, maybe it would have been okay to buy that larger house. When we started out, often times, if you're set up the right way, illiquidity could have been in your favor looking backward.
Yeah, to that point, probably the first question we should ask before we talk about liquidity versus illiquidity is what do you want to do in your life? What are the decisions you want to make? What type of cash flow do you need? Are you in your working years? Are you in your retired years? I mean, all of these questions need to be answered first before we even get into the liquidity versus illiquidity.
Do you generally have an estate tax problem? How much access do you want your kids to have to money or assets? I mean, it's it's somewhat ironic as we talk about this and not everybody's goal is to amass as much wealth as possible. Yeah, but oftentimes you look at very wealthy families, the assets that are passed along to generational businesses, real estate entities that are not liquid.
And they're somewhat done by by design because they don't want that money to screw them up. And so having it where it's producing income but you can't click a couple buttons to sell is actually help.
Yeah, I mean, a 30 year old inheriting $1,000,000 in cash versus $1,000,000 in investments in illiquid, you know, businesses or something like that, they'll make different decisions. And so there's times where illiquidity can act in your favor if that's important to you from passing on a values standpoint to future generations.
So one of one of the cons, I mean, like having the right investment in the right structure so that way you have access to it or not can, can make a huge difference in returns or results that you receive from it. I mean, stocks should not be liquid. Yeah, first and foremost, it's somewhat silly that you can try to accurately price a company like Apple or Google on a daily basis.
But you know, stocks are ten plus year investments. Yeah, and so are things like real estate or businesses. And they shouldn't be in an in a structure where you can click a couple of buttons and sell in a given day. I mean, if you had to sell your house today. Yeah. I mean it's it's 12:00, If you had to sell your house by the end of the day, are you getting the best possible price or.
Yeah. So, you know, having paying attention to illiquidity and what type of investment in it not only could produce outsized returns, but could be in your best interest when it comes to the price, when you have to, you know, sell or get that liquidity?
Yeah, I mean, it's a good point. But even with real estate, if you were to buy and sell it daily, you'd have closing costs and fees to pay and moving expenses and you had to like clean the carpet and you got to fix the pay and all of the things that come along with buying and selling real estate.
I mean, in many ways that it would be inappropriate for that to be illiquid investment because it takes time for things to come to fruition.
Kind of like gardening. Yeah.
I was sharing a story with Chris that when I think about illiquid investing, I think about it in the same way I think about gardening. This is something new that I've been getting into and when you plant, let's say something to produce cucumbers, you plant it and it takes 2 to 3 months for you to see the leaves start to just really come out.
And then all of a sudden you see like a little tiny glimpse of a cucumber and it's very small and it's growing and it's growing and it's growing. And if I were to like, cut it early and try to eat that cucumber, it would not taste good. It like, that's not what it's meant to do. It's meant to go all the way to the point where it's ripe and ready to be picked.
I pick it. And what's interesting is that when you pick it and what happens is it gives nutrients. So the rest of the cucumbers and now you have like this amazing resource for food, I think about gardening and some illiquid investments like real estate. In the same way when you buy real estate, you often have to fix the parking lots, you got to redo the carpets, you've got to put in energy efficient appliances.
And so there's a cost to it for a period of time, and you have to be very patient. But then once you get everything rented and you're getting that income stream, it's very fruitful, pun intended. And I think that we should be thinking about illiquid investing in the same way we think about gardening, where it takes patience. But if you do the right things and make the right decisions, it can actually provide a lot for you in your life.
So I love that analogy mainly because I don't know what if it's the life cycle that we're in, but I was trying to do some gardening. We were growing some heirloom tomatoes. You know, they're different color. They're not all that bigger. I kept getting in trouble because I was picking them too early.
Because you weren't waiting for them.
I wasn't ready for the third, so it made me laugh. But yeah, I mean, real estate is a great example. It takes time to find, acquire, fix up, increase rents in. Those are things that you can see day over day. Yeah, I mean, we look at our brokerage accounts and we can see the price of mutual funds or stocks or bonds priced every day.
But how many of us look at our house value every single day?
Yeah, yeah, we should. And even I do get price alerts from some real estate agents that. But yeah, it doesn't quite matter, right, because we're in it for the long term. And I think that in many ways it's healthy to house on illiquid investments because it forces you to not look at it. It actually produces a a good mindset.
You think to yourself, this is something that I want to have for a long period of time. I don't care about the short term fluctuations because it's really about the long term result. And I think that that's actually one of the benefits of illiquidity. When I first got into this industry, I was a little bit nervous about it.
Have to make a commitment to this investment for one year or three years or ten years. But then as I learned more and more, I realized that it a can produce outsized returns, but then more and.
More even just consistent.
Consistent returns. But then B, I think that in many cases it produces just the right mindset for any investor.
Yeah, it's funny that you mention that. I came across some study. I believe it was Harvard. I may be wrong on this, but, you know, they basically had two groups of students that would manage just a small portion of their endowment, and one group of students got to make decisions on a more frequent basis, call it weekly or monthly.
The other students just basically set up the investment structure and then ignored it. And over the last 25 years, it is just glaringly obvious that the group that just sort of set it and forget it is doing way better than any other group. But it takes time for for investments to to produce returns or to see things grow.
And where I think people go wrong with making illiquid investment decisions is they either do it in the wrong account, an account that they need access to that money for a different reason, right? Or they don't have the right amount of money on hand to weather the storms of life in the unexpected things, whether that's an emergency fund or money liquid to go buy another house.
That's where people go wrong when it comes to investing. And so that's why it's really important to have that conversation upfront.
You should be thoughtful to how much do I need in an emergency fund? What would cover a 3 to 6 months of expenses or debt servicing or whatever the things are in my life where I would need that time on my side to recover? I think it's important for there to be some liquidity in every investors portfolio, and some of it is for the emergency fund purposes, but some of it is just dry powder to wait because new opportunities come all the time.
And having liquidity allows you to actually invest in some of those new opportunities. So when we work with our clients, we're always thoughtful to making sure there is liquidity in the portfolio, but we just want to make sure that we're not choosing liquidity over choosing investments that we think are in the best interest of the clients, which oftentimes are illiquid in essence.
Yeah, definitely. I mean, you just look back at Jeff Bezos. He quit his job as a hedge fund manager and says, I'm going to start Amazon selling books online. Right. His entire net worth was in a company called Amazon. And, I don't know, maybe living at your parent's house in their garage, you know, helped him meet his needs and not have much liquidity.
But oftentimes when you take on some illiquidity, it can be for your benefit and produce outsized returns. When we were talking earlier about not only the right account, but there are some things that feel liquid that are. Yeah, we run into people from time to time that, you know, paid down their house or owned their house. And then the other accounts that they have is just like an IRA account.
And so they might feel like they've got money, but they're actually very illiquid. Yeah, you can't just write a check against the value of your house. You might have a home equity line of credit, but that's not really how that works. And then when you have a large IRA, every dollar you take out, you have to pay taxes on it.
So, you know, that doesn't feel like you have access there either. So you know, depending on your assets or the type of accounts, you may feel liquid, but you still might not be.
It's why it's important to talk through these things, because we'll have clients come to us all the time and ask to pay down their mortgage faster just because they want it paid off, like the freedom that they would feel from a house that's paid off is real. And I don't blame anybody for that. I actually think that psychologically that is really helpful.
But the problem is you don't want to end up in a situation where the technical term is house poor for okay, rich, where you have all your money in your house, which you can access very easily, or you have all your money in your 401k, where every dollar you take out, you've got to give $0.25 or $0.30 to Uncle Sam on the dollar, sometimes more than that.
If you don't have a third bucket, a bucket of personal moneys, that can actually be very complicated, especially I think later in life when you've got to be thoughtful to long term care and other emergency expenses, that could be very expensive. You want to make sure that you have a third bucket that's probably about equally as big as the borrowing bucket, because then you'll be able to access your money you can without having to pay taxes on every dollar that you pay.
Income taxes that might be subject to capital gains, which could be last. But, you know, that example, I mean, there are so many people that fall into that category and debt plays funny tricks on your mind, right? We have these emotions towards towards debt. And sometimes you can have a scarcity mindset towards money. And so we're like, you know, I got to pay off that debt.
I don't want the bank to own me. But the power of a 30 year fixed rate mortgage is like, imagine like $3,000 a month is a lot of money. Yeah, but $3,000 a month today felt like where you were on the clock. 20 years, $3,000. Felt like a lot more money back then than it does today. So paying off your loan, there's this whole thing called inflation where your dollars, you know, don't buy as much goods and services down the road.
Well, that that rings true for your mortgage, too. It might be an expensive mortgage today, but it might not feel like very much in the future. So you might be better off instead of paying down your mortgage or paying off all your debt, you might be better off saving some dollars on the side of it.
Yeah, I think so. And you know, clients or anyone listening to this might be asking the question of like, okay, this is a lot of information now what do I do? Yeah, I like that. So we talk a lot about a budgeting approach right at more, Maureen, where we think about the different buckets that our clients need, what they need it for, and then we kind of create a liquidity timeline, if you will, based on that.
So let's just say as an example, and the percentages are different for every person, 25% of your money is in things you can sell daily or it's in cash, something that you can access the money fairly quickly if you needed it. Fixed income, Yeah, maybe 25% of your money is in short term illiquid assets, something where you could access a quarterly or within a year.
It produces income, which is always one of the things that we look for is that we want to have liquidity while we're illiquid. Let's get that cash flow going. Maybe another third is in things that are mid-term illiquid and then another or 25% and then 25% is in long term way, which sometimes you put stocks in that.
Category, stocks should 100%. Stocks should be ten plus year.
Yes, thinking about it that way. And so when you're going through your financial plan or your cash flow plan, I think it's important to not just take into consideration when investments am I in in general, but what am investments I am and what is the liquidity timeline of those investments? And based on my goals and my needs, does that make sense?
And that's something that we work with our clients on all the time because we don't just do alternative investments to be cute or trendy. We do these private alternative investments because we actually think that that will serve our clients best. And we recognize that part of serving our clients best is being really thoughtful to when they'll need access to those moneys.
Yeah, I love that. And you know, the bucket approach is key. Oftentimes people make decisions based on, you know, investment decisions or purchasing decisions based off the income that they have coming in. And the way that this always goes wrong is if someone doesn't have enough of emergency fund, they don't have enough income coming in and they've got money in illiquid investment, It's just a recipe for disaster.
So thank you so much for sharing that, Stacey, and I appreciate you being a guest.
Disclosure: Information and references to specific investments presented herein are for educational purposes only, are not intended as an offer or solicitation with respect to the purchase of any security or asset class, and should not be relied on for investment recommendations. Also, the Information herein is not written or intended as tax advice and may not be relied on for purposes of avoiding any federal tax penalties under the Internal Revenue Code. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. The investments discussed may fluctuate in price or value. All investments involve risk, including theloss of principal. Past results are no guarantee of future results. You should consult with your financial advisor to thoroughly review all information andconsider all ramifications before implementing any transactions and/or strategies concerning your finances
