The Paradox of Illiquidity—Expanding Investors’ View of Diversification
While investment managers and their clients share a common goal, they often disagree over strategy. Sophisticated investors know, for example, that balancing liquid and illiquid assets can potentially capture the benefits of diversification and the “illiquidity premium,” i.e., the higher return potential of deferred liquidity investments. Nevertheless, many investors demand liquidity—and typically exercise it at the worst time in the investment cycle. When investment managers can deploy capital into distress, rather than liquidating assets at bargain basement prices, their clients are better-positioned to potentially reap the level of returns that both parties desire. In this post, Frank Muller examines this aspect of behavioral finance and explains the need for advisors and their investors to include illiquid strategies in their definition of portfolio diversification.