A Berkshire Hathaway Fire Sale - The Behavioural Benefits of Illiquid Investments

The Berkshire Hathaway Fire Sale

The axiom ‘buy low and sell high’ is often among the first maxims that anyone learns about the stock market. But as any experienced investor knows, it’s much more common to find people chasing trends, or fleeing fads that leave them doing just the opposite.

Among the myriad sad stories that have resulted from this tragic behavioural tendency, one that’s particularly poignant for if nothing other than the players it involved was related by legendary investor Edward Thorp, a renowned mathematician and hedge fund manager, in his book "A Man for All Markets".

In his book, Thorp recounts how in 1985 his divorced housekeeper received a $6,000 settlement from an automobile accident. Knowing his acumen for finance, and wanting to put her two kids through college, she begged him for investing advice. At first, Thorp was reluctant to recommend any specific course of action, but his house keeper’s repeated pleas finally made him acquiesce.

Thorp’s recommendation to her was to buy the stock of a company run by a man who he had become friends with, a very promising investor who had established his own public investment vehicle called Berkshire Hathaway. But it came with a covenant of sorts, he made her promise that she would never sell it without checking with him first. His housekeeper dutifully bought 2 shares of BRK for $2,500. Years later, after his housekeeper had moved on to another job, he learned from her broker what had happened:

She later left housecleaning for office work and we lost touch with her. Meanwhile BRK rose to about $5,000 a share just before the October 1987 crash. I learned later from the broker that Carolyn had sold near the post-crash bottom at $2,600 a share. Sixteen years later, in the first quarter of 2003 at the time her children might have been finishing college, the stock ranged between about $60,000 and $74,000 a share.  – Edward Thorp, A Man for All Markets

Many reading this will recognise behavioural the elements that underly this story as all too common in the world of investing. Thus, it is for these and other reasons which we will discuss, that many financial planners have started to incorporate illiquid investments into their clients' portfolios, recognising the behavioural benefits that they can convey.

In this article, we'll explore the behavioural benefits of illiquid investments and discuss how financial planners can use them to help their clients achieve their long-term financial goals. But first, let's define what we mean by illiquid investments.

What are Illiquid Investments?

Illiquid investments are assets that cannot be easily bought or sold on public markets. These assets may include private equity, real estate, private debt, and other types of alternative investments. Unlike publicly traded stocks and bonds, illiquid investments often require a long-term commitment from investors and may have limited liquidity options. This means that investors may not be able to access their capital for several years or more.

Why Invest in Illiquid Assets?

While illiquid investments may not be suitable for all investors, there are several potential benefits to investing in these types of assets. One of the primary benefits is the potential for higher returns. Illiquid investments may offer higher returns than publicly traded stocks and bonds simply because they cannot be bought and sold at a moment’s notice – a phenomenon known as the illiquidity premium.

For example, a private equity firm may invest in a startup company with high growth potential and hold that company among its portfolio companies for several years. If the company is successful, the returns to the private equity firm and its investors can be substantial.

Another potential benefit of illiquid investments is the potential for diversification. Illiquid investments may provide exposure to asset classes that are not available in public markets, such as private real estate or infrastructure. By diversifying across different asset classes and types, investors may be able to reduce their overall portfolio risk and potentially achieve higher returns.

However, perhaps one of the most significant benefits of illiquid investments is their potential behavioural benefits. By their very nature, illiquid investments often require a long-term commitment from investors, which can help to counteract some of the emotional impulses that can lead to poor investment decisions.

Reduced Market Noise & Impulsivity

When investors are constantly bombarded with price information from the market, it can be difficult to separate signal from noise. Illiquid investments, inherently less subject to this market clamour, allow investors to concentrate on the fundamental aspects of the investment. This focus on fundamentals encourages another key advantage of illiquid investments: reduced impulsivity.

Academic research has shown the benefits that less activity can have for investors. In their influential study, Trading is hazardous to your wealth: The common stock investment performance of individual investors, researchers Barber and Odean reviewed the trading activity and portfolio performance of over sixty-six thousand American households over five years. They found that even in a rising market, the most active traders significantly underperformed the market.¹ This study bolsters the argument that those with the inclination and ability to actively engage with the market often suffer the consequences of emotionally driven decisions.

Illiquid investments offer a potential antidote to this common behavioural pitfall because they, by their nature, often enforce a long-term commitment. Their barrier to exit can help to counteract the impulse to sell during times of market volatility or chase returns elsewhere. By raising hurdles against impulsive decisions, illiquid investments can promote more thoughtful and deliberate investment behaviour, leading to better long-term returns.

Increased Alignment of Interests

Illiquid investments often involve long-term commitments between the investment manager and the companies or projects they are investing in. For instance, when private equity, or venture capital managers purchase controlling stakes in a company or asset and work for years to increase the value of the asset. This can foster a better alignment of interests across investors and their investment managers as both have a shared goal of benefiting from long-term value creation.  

Distinct Opportunities for Diversification

The composition of most leading indices, and even numerous active funds, is dictated by the market cap weighting of the index constituents. Consequently, even active strategies may have limitations in the unique or idiosyncratic risks they can assume. Illiquid investments, however, often involve off-market assets that span a variety of sectors and industries, allowing for portfolios with distinct attributes.

For instance, infrastructure investments such as toll roads, bridges, or renewable energy projects; ownership or stakes in airports; or insurance-linked securities like catastrophe bonds, provide unique risk and return characteristics that can be difficult to replicate in public markets. More esoteric investments, such as private debt, direct lending, or venture capital and green private equity, can offer further opportunities for diversification. These distinct investments can offer diversification benefits that are challenging to achieve with public market referencing products, thereby amplifying overall portfolio diversification and contributing to an enhanced risk-return balance.

The Benefits of Constraints

Illiquid investments can provide investors with several benefits, including the potential for higher returns, diversification, and behavioural advantages. By their nature, illiquid investments often require a long-term commitment from investors, which can help to counteract some of the emotional impulses that can lead to poor investment decisions. Thus, with thoughtful planning and careful consideration, illiquid investments can be a valuable addition to clients' portfolios.