In his book Margin of Safety, Seth Klarman discusses managing the portfolio liquidity cycle. Here’s an excerpt from that book:
When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine.
Investing is in some ways an endless process of managing liquidity. Typically an investor begins with liquidity, that is, with cash that he or she is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew. This portfolio liquidity cycle serves two important purposes.
First, as discussed in chapter 8, portfolio cash flow—the cash flowing into a portfolio—can reduce an investor’s opportunity costs.
Second, the periodic liquidation of parts of a portfolio has a cathartic effect. For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. “Dead wood” can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.
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