Illiquidity Preference and Risk Attraction

In the fixed-income world--the land of yield curves and quality spreads--two principles usually hold true:

1. Liquidity Preference: Based on their preference for liquidity, investors are willing to accept lower yields on shorter-dated investments (instead of risking possible loss of principal on the early sale of higher yielding longer-dated investments). Hence, the yield curve typically has a characteristic positive slope, with short-dated money market instruments yielding less than longer-dated notes and bonds.

2. Risk Aversion: Similarly, since investors are willing to pay a premium for safety, bonds of lower credit issuers often trade at even wider quality spreads (lower prices) than necessary to compensate for their additional default risk. The story goes that Michael Milken, the former "junk bond" king, noticed this behavior in the bond markets early in his career and was able to capitalize on it, prior to his slippage into illegal trading activity that prematurely ended his lucrative securities career.

To maximize returns in a fixed-income portfolio, it usually makes sense to extend out on the yield curve to longer maturities and to buy below-investment-grade credits to boost portfolio yield. I would even venture to say that for investors with very long time horizons (such as university endowment funds, or high net worth individuals), holding exclusively long-dated bonds and junk credits will produce better returns than a mix that includes shorter maturities and high-grade credits.

How about in the equity markets? Does it make sense to own more illiquid, higher risk stocks (and real estate)?

I tend to believe that, in long-run investing, "principles" analogous to those for fixed-income investing should hold true for equities, viz.:

3. Illiquid equities (e.g., small-cap stocks) ought to perform better than more liquid investments; and

4. "Risky" equities (i.e., high beta stocks and venture capital) ought to provide higher returns than less risky equities.

The basic reason is the same as for the fixed-income markets: Investors, who generally prefer liquidity and are risk averse, tend to "bid up" liquid, low-risk investments, while neglecting illiquid, high-risk investments. As such, illiquid, more risky equities are often available at a discount to "fair value."

So, for the investor with a very long-term time horizon, illiquid and high beta stocks should produce the best long-run returns. Sure, there will certainly be times when these high-risk investments perform very poorly versus market averages; however, patient investors who are able to ride out the downturns ought to come out ahead in the long run.