Why Illiquidity Can Be Good

Topic:  • By Origin Investments • January 13, 2016 Views

“Imagine you have just been given $1,000 and have been asked to choose between two options. With option A, you are guaranteed to win an additional $500. With option B, you are given the chance to flip a coin. If it’s heads, you receive another $1,000; tails, you get nothing more. Which option would you choose?

“Now imagine that you have just been given $2,000 and are required to choose between two options. With option A, you are guaranteed to lose $500. With option B, you are given the chance to flip a coin. If it’s heads, you lose $1,000; tails, you lose nothing. Now which option would you choose?”

This test, pulled straight from the book “Why Smart People Make Big Money Mistakes” by Gary Belsky and Thomas Gilovich, illustrates why illiquidity can be a good thing.

"Why Smart People Make Big Money Mistakes" by Gary Belsky (L) and Thomas Gilovich (Simon & Schuster; Twitter @GaryBelsky; socialpsychology.org)

Studies have found that most people choose option A in the first scenario, the guaranteed $500 win, and option B in the second scenario. They take a chance to avoid the sure $500 loss. In other words, human brains are wired to take on additional risk to avoid losses, while acting more conservatively when a win is a sure-thing.

There are lots of fancy psychology terms to describe this, but at an emotional level “people feel more strongly about the pain that comes with a loss than they do about the pleasure that comes with an equal gain” — twice as strong, in fact, Belsky and Gilovich write.

And this often leads to making really stupid choices.

When investing, the most common stupid choice that results from it is panic selling. The pain of a stock market crash is so great people flee at the bottom, at precisely the time they should stick with it.

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This research from Nejat Seyhun really drives this point home. Again, quoting Belsky and Gilovich:

“By pulling your money out in short-term drops, you run the risk of missing those productive days. And it’s a serious risk. … If you missed the 90 best-performing days of the stock market from 1963 to 2004, your average annual return would have dropped from almost 11 percent, assuming you had stayed fully invested, to slightly more than 3 percent. … On a $1,000 investment, those different rates of return translate into the difference between having $74,000 after four decades or having about $3,200.”

There’s a difficult aspect to this concept because mistakes go the other way, too. Because the pain of a loss is so great, it also can lead people to hold on to losers for longer than they should. Because you’re just sure it’s going to come back. Right?

This is why you hire professionals, “so you can’t make dumb investment decisions,” as Origin cofounder Michael Episcope put it. Even Episcope, a former trader on the Chicago Mercantile Exchange, hires experts to handle his non-real estate investments, about which he knows less.

“I got into a Bain Capital (private equity) fund in 2006,” Episcope said. “In 2009, they were reporting a .6 multiple. (That is very poor.) I remember thinking when the market first crossed 10,000 how I would have sold everything if I could have. It felt like I had just made 50 percent because the market had rebounded from 6,500.

(Article continues below video)

Watch Michael Episcope explain how illiquidity can benefit your investment portfolio.

“Bain didn’t sell. They held on and didn’t sell a single company until 2013. They have been scaling out slowly, and I have enjoyed riding up the market the entire way. I hired a manager for a reason. They are in the trenches, have the knowledge and expertise, and did better than I ever could have. Thank God I didn’t have the ability to sell when my emotions were at their peak. The ‘liquidity premium’ that people supposedly pay for would have cost me a lot of money.”

Origin’s hold period on most of its real estate is five to seven years; such illiquidity — as long as you don’t anticipate needing that money — is wise. It prevents investors from overreacting.

And once such an investment has been made, we have one more tip.

According to Belsky and Gilovich, “numerous surveys indicate that anywhere from a third to half of investors check their stock portfolios once a week, if not more frequently.”

Don’t. Once a year is enough. Doing the daily and weekly checks is our job.

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Origin Investments

Origin Investments is a top-ranked real estate firm committed to educating investors on private equity commercial real estate.