The good and the bad of illiquid investments

You need not choose illiquid assets just to overcome your temptation to spend

There are many reasons why individuals prefer real-estate investment, and illiquidity features among the most important. You may wonder what is good about illiquidity. In this article, we discuss why many individuals prefer illiquid investments while pursuing high-priority goals, and the risks associated with it.

Fighting temptation

Choosing between savings and spending is a mental battle. Most of us prefer current consumption to saving for a more secure future.

On a philosophical note, we do not know how long we will live. So, saving for a future that may not happen does not sound as exciting as spending today. On a behavioural side, the pain of cutting current consumption to save for the future is much higher than the pain of not having enough money in the future. Psychologists call this present bias.

We tend to misuse investment liquidity because of present bias. You may be tempted to redeem your investments and spend the money on material goods or lifestyle experiences today, even though the investments may be earmarked for a life goal.

This problem is more acute with emergency money, for resisting the temptation to spend emergency cash is emotionally draining.

But spending only for current consumption is not good because you may never achieve important life goals.

One way you can resist spending is by investing in illiquid assets such as real estate — you will not spend the investments you cannot redeem. But illiquid investments expose you to a different risk.

You may fail to achieve your goal because you cannot lock in to unrealised gains on your illiquid investments. So, illiquid investments are good if you earn only interest income, but not so if you are looking to earn capital appreciation.

Capturing gains

Suppose you invest in bank deposits and equity mutual funds to finance the cost of your child’s college education 10 years hence. You should opt for cumulative bank deposits instead of annual interest-paying deposits. That way, you do not have to resist the temptation to spend the annual interest income.

But the argument for illiquidity does not hold for equity investments. Suppose you expect an annual pre-tax return of 12 per cent on equity, but you earn 15 per cent in a year.

What should you do? If the investment is illiquid, you risk losing your capital appreciation, for the investment has to decline only 13 per cent to claw back all the unrealised gains. You, therefore, need liquidity to manage your equity investment.

So, how should you create an investment portfolio that has liquidity to capture gains on risky assets and yet not tempt you from redeeming the investments for purposes other than meeting your life goal? Studies have shown that you are more likely to stay focussed if you can visualise your life goals.

So, how about naming your equity investments as ‘child’s education fund’ or ‘down payment for the house’? In addition, you could make equity investments in your spouse’s name and let your spouse control the redemption.

Importantly, you need not choose illiquid assets just to overcome your temptation to spend.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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