Liquidity

The ease of getting in and out of stocks drives madness in the market

The stock market is said to be liquid, meaning stocks can be bought and sold easily and inexpensively. This causes prices to move more than they otherwise would if it was illiquid.

Think of the real estate market: imagine your home (if you have one) was quoted daily—its price movements reported to you, rather by the minute, like stocks. What would people do? Most people would watch home prices like a hawk; watching them gyrate up and down. It would cause some people stress. Some people to do things they otherwise shouldn’t, like panic sell when their house price is down. Liquidity in other words, with the real estate market, if it were liquid, would cause irrational behaviour, like it does with stocks.

This is why you get so many booms and busts in the stock market. Stocks are liquid. And people are emotional. A bad combination.

John Maynard Keynes, the great economist, likened it to a farmer checking his barometer each day, and based on its reading, deciding whether or not to sell his farm:

The Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the individual as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return it later in the week.

People behave just like this with stocks.

Which creates opportunity for the rational investor. And trouble for the irrational investor.

I cannot stress just how important it is to control your emotions in investing. To control your behaviour. It is probably the single biggest factor in success in investing.

Not being influenced by daily gyrating prices.

Back to real estate. It’s good that real estate prices are not quoted daily, or by the second like with stocks. It would cause all sorts of emotional distress for people.

With stock prices down about 10 percent this year, how much would housing prices be down? I imagine by a fair amount. But prices aren’t quoted daily, so no one knows. Real estate is illiquid, unlike with stocks, so it takes longer for prices to adjust. Sometimes they don’t much at all, like they should, like in 2022 when virtually every other asset class was down significantly.

This is the benefit of illiquidity, it causes people to act more rationally, to take their time in making a decision, unlike with stocks, where people are fueled by emotional outbursts.

So stocks are liquid and liquidity can be bad if you’re influenced by price movements, which aren’t always—and often aren’t—rational.

But liquidity can be good if you are rational. It allows you to buy and sell stocks easily when you want to; and take advantage of buying opportunities in the market.

When people panic—that’s the time to buy. When the price of a perfectly good company, or investment fund, is down by 40 percent, that’s like buying groceries on clearance. It’s a good thing and a benefit of liquidity with stocks.

Imagine house prices dropping by 30 or 40 percent in a year. It very seldom, if ever, happens. But it fairly often happens with stocks.

At the start of the Covid-19 pandemic, in a month, they fell by 30 percent. A few weeks ago, as people panicked over Trump’s tariffs, they fell by 15 percent in a few days. Crazy? It’s normal with stocks.

Liquidity can drive temporary insanity with stocks as the late Charlie Munger, Warren Buffett’s business partner, spoke about at Berkshire Hathaway’s 2004 annual shareholders meeting:

I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle. The liquidity gives us these crazy booms, so it has as many problems as virtues.

My advice: avoid focusing too much on price quotations. Stock prices bounce around. If you’re invested in stocks, you have to accept it. If you have the courage and ability, take advantage of stock prices when they’re down and buy undervalued companies. Let liquidity work for you.

But never let it handicap you, as it does many investors.