This past weekend I went to a place called Funplex. As the name suggests, it was fun. As per their website, it is an “ultimate indoor amusement park…rides, arcade games, and attractions for the whole family.” Funplex offers something for everyone. If you don’t like fast rides, why subject yourself to one when there are alternatives all around you? Why do people with different risk appetites (i.e., thrill seekers versus risk averse) and investment horizons subject themselves to the same risky investment rides if they don’t need to?
Over the course of my career, I have shifted into and out of investments across the liquidity spectrum, and I keep coming back to the same question: Why do we affiliate the volatility of an investment with its actual performance? Volatility is a statistical measure of an index or security’s return dispersion. In laymen’s terms, it is how much a price moves up and down, an experience comparable with two rides at Funplex: the Moseride, which lifts you up and then drops you, over and over again, and the Skyscraper, which takes you up and around and down in a square motion again and again. With both rides, you start at the bottom and go up and down or sideways. But at the end of the day, if you even end up higher than where you started, but feel sick after you get off the ride, was it worth it?
Often times people affiliate the ability for a bond to change hands as the same thing as its actual capability to perform. Consider bond prices. Let’s assume hypothetical Company B (for Bond) has a track record of making all of its payments, so you lend the company money via a bond issuance and they agree to pay you back – and then they do. In theory, a bond’s “price” shouldn’t move much if the issuer is making its payments.
It gets tricky, however, when we look at a bond’s price in relation to prices for similar bonds. How good or bad Company B’s bond looks relative to these others can impact its price. Again, if you hold the bond to maturity, it makes it payments as planned, and you don’t look around at comparable bond prices, Company B’s bond price shouldn’t move much at all.
The same is true for loans. Loans are obligated to make payments on a regular basis (I.e.- quarterly), and if they stay up to date with these payments, they are what is referred to as “current.” If a loan misses or delays a payment, then the clock starts ticking. We all have rent, mortgages or credit cards, and as such are accustomed to this dynamic. Once again, a loan’s price movement doesn’t always equate to its actual performance or its ability to repay the underlying investment. If you’re an investor with a long-time horizon and a low comfort level with price volatility, then why subject yourself to it when there’s an alternative?
Back when I worked at a bank helping manage their $15 billion mortgage portfolio, we were required to choose the accounting method we would apply to each security we purchased based on what we planned to do with it. For instance, if we bought a loan with the purpose of selling it as quickly as possible, we were subject to an accounting standard called “held-for-trading.” That required us to price loans every day and realize the gain or loss as if it was sold, also known as mark-to-market. Conversely, if we planned to hold a loan to maturity, we used an accounting standard known as “held-to-maturity.”
For the most part, the loan prices didn’t really move unless there was a default. Generally, we would buy them for a certain price, and they would amortize or accrete to the price expected at maturity, typically par or face value, regardless of daily market movements.
A third “available-for-sale” accounting standard covered everything in the middle. We used this standard when we didn’t have firm plans to trade or keep a loan until maturity. Every day we marked the prices according to the market on that day but we didn’t realize a gain or loss. We only took a realized gain or loss if there was a material movement in pricing.
Why is it important to consider all those accounting terms? Because in our view, individuals and advisors should really take the time to bucket the purpose of their money and investments just as institutions are required to do. For example, I have cash accounts for everyday living, investments, 401K, company stock and IRA accounts for everything else. If you don’t have any real plans to use the money in the foreseeable future, then why suffer potential whiplash when you don’t need to? Why not take a gondola ride that allows you to periodically step off along the way as you head up (or down) the mountain for incredible views. That said, even gondola rides can stop briefly, rock and can even go backward a little bit, but they still eventually move forward without changing course.
If you don’t need capital immediately, then don’t subject yourself to market volatility or, ultimately, the price movements associated with an investment’s ability to change hands at the whim of anyone. Liquidity can equate to volatility. Do you need to get on a roller coaster ride for all the money you invest if you don’t plan to use it every day? If not, enter the gondola, sit back, relax and enjoy the ride using investments that have limited liquidity (e.g., interval funds). Although there are restrictions on when you can access capital, all interval funds must provide between 5-25%. This can allow you to potentially access capital when you may need it, for example, college funds or retirement, and not the markets to determine when you get on and off the ride.