Seth Klarman: Liquidity Can Be Illusory

Johnny HopkinsSeth KlarmanLeave a Comment

In his book – Margin of Safety, Seth Klarman discusses why liquidity can be illusory. Here’s an excerpt from the book:

Liquidity can be illusory. As Louis Lowenstein has stated, “In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.”

In other words, while any one investor can achieve liquidity by selling to another investor, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate-share repurchases.

Except for such extraordinary transactions, there must be a buyer for every seller of a security. In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion.

During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue.

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.

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