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The Upside of Private Market Illiquidity

By: Gridline Team | Published: 11/18/2022
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Est. Reading Time:
3 minutes

Liquidity, or the ability to quickly turn an asset into cash, is conventionally seen as a desirable trait. It's what enables millions of traders worldwide to buy and sell stocks and bonds with the click of a button.

In comparison, private market assets like venture capital and private equity are often seen as riskier because it can take years to cash out. In reality, this illiquidity is a feature, not a bug, which allows investors to hold over market cycles and ultimately earn higher returns.

Illiquidity forces "time in the market."

A popular investment saying goes, "time in the market, not timing the market," which is what matters most for returns. The data bears this out. A study by Fidelity Investments found that investors who missed the ten best stock market days missed out on 55% gains.

If you're trying to time the market, you will inevitably miss these big days. But if you're invested for the long haul, you will participate in the market's ups and downs, capturing the gains when stocks rise and weathering the losses when they fall.

This is where illiquidity comes in. Because it takes longer to cash out of an illiquid investment, you are effectively forced to stay invested for the long haul. This "time in the market" allows you to capture the market's ups and downs, which is essential for higher returns.

Moreover, over the long term, stocks have never lost money. There's never been a 20-year period where stocks have declined in value. That's why Warren Buffett famously said, "if you aren't willing to own a stock for ten years, don't even think about owning it for 10 minutes."
Simply put, illiquidity protects you from redemption risk. This is the risk that you will redeem your investment at a poor time, which is exactly what most investors do, causing them to underperform market indices consistently.

The power of the liquidity premium

Beyond forcing you to stay invested, illiquidity also allows you to capture a risk premium in the form of higher returns.

The size of the premium varies depending on the asset, but one PIMCO analysis puts the private market liquidity premium at around 1.8%. That’s not counting the complexity premium of private markets, nor is it counting the additional alpha that fund managers can create.

Still, this alone can significantly impact returns over the long term. For example, let's say you have one investment of $1 million without a liquidity premium that returns 5% annually. After ten years, you would have $1.6 million. If you had another equally sized investment that added a 1.8% liquidity premium, you would have $1.9 million after ten years – a 19% increase.

The benefits of illiquidity are especially pronounced in retirement accounts, such as 401(k)s and IRAs, where the money is meant to be invested for the long term.

The bottom line

Liquidity is often seen as a desirable trait, but it can make you a worse investor. Illiquidity, on the other hand, can provide significant benefits, such as forcing you to stay invested and providing a liquidity premium, not to mention the tax advantages of long-term investing.

For long-term investors, these benefits are hard to ignore. With Gridline, you can access top-quartile private market alternative investments, typically only available to sophisticated family offices and endowments. Gridline's mission is to open up access to these investments transparent, efficiently, and lower-costly.

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