MediumTex wrote:
The concept is that for each PP asset there is a declining marginal utility to each dollar when it comes to liquidity.
I want to build on this a little further:
Liquidity is valuable. The ability to sell your assets easily is something desirable. Considering two investments, equal in all respects except for liquidity, the higher expected returning asset must be the one with less liquidity. Pretend Investment A was perfectly liquid. Investment B has a 6 month waiting period to sell, from the period you decide to sell. Both investments are "bonds" issued by the same entity, with equal creditor rights.
Investment B is expected yield more than Investment A, because people would require a higher return to accept the 6 month waiting period.
Thus, liquidity comes at a price. It's not "free." All else equal, you are sacrificing expected return for increased liquidity.
Add this to MT's brilliant statement, that there is diminishing returns for marginal utility for additional liquidity within a given asset in the PP, and we realize that there is an efficient sweet spot whereby one can maximize total return, according to liquidity-utility measurements.
For example, IBonds have a higher return than a CD, but you can't sell the IBond for the first 12 months. So there is initial illiquidity. You would be foolish to go 100% IBonds as your cash portion (ignore annual max limits for this example). However, you would be equally foolish to go 0% IBonds, because you are leaving money on the table by not taking on slightly reduced liquidity for a higher return.
There's some efficient point between 0% and 100% to be in "deep storage" within an asset. We could probably calculate it, at least historically, based on what percentage of any given asset the PP needed to sell at any given time. i.e. if the PP has historically never had to sell more than 50% of any asset to enable a rebalancing event, then the liquidity levels only need to be a 50%. In fact, one might argue to go 60% illiquid, because the probability of needing the full 50% is low, assuming 50% was the historical maximum.
The PP is all about simplicity, and I think it would be fine to ignore this thread if you are a beginner or not interested in tinkering slightly. However, I think we can potentially juice an additional 0.5% to 2% return per year, by considering this methodology, while keeping standard deviation nearly the same. In essence, it would be risk-adjusted free money compared to the regular PP.
For some examples, liquidity deep storage could be something like using a 3 year Treasury note instead of 1 year T-Bills for some of the cash portion. You get a higher return for pushing further out on the yield curve. There's more risk because the principal could fall if interest rates drop, but if it's deep storage and you hold until maturity, there is reduced risk. The risk comes from the fact that hyperinflation could push yields up on new T-Bills and by having your money locked up for 3 years you are forgoing that new higher issue rate.
That's why a TIPS might be a good thing for deep storage cash as well, since the coupon rate will vary based somewhat on inflation (depending on how the government decides to calculate it).
I don't think there's any deep storage opportunities for Long Term Bonds or Gold. I understand MT's point that the physical bonds are "deep storage" because it's more of a hassle to sell than an ETF like TLT, but there's substantial liquidity in the bond market, so you're not really gaining value from a liquidity standpoint. Same with gold. The value you gain by holding actual physical gold or directly owning bonds, is not from accepting decreased liquidity, but the value comes from reduced counterparty risk. There is a cost associated with reducing counter party risk, and that cost is measured in expense of selling treasuries on the secondary market (in both your time, and potentially brokerage fees), and the spread on gold bullion being much higher than the spread on ETFs.
There may be liquidity-value to gain in stocks but one would have to own private equity. Typically PE is less liquid than publicly traded stocks, and the expected return is higher to compensate for the reduced liquidity. The problem is most people can't access PE because you'd likely need at least $10k+ to find a business worth owning to sell you shares. And then diversification becomes a problem since you'd have to have several hundred thousand dollars in stocks to really diversify among PE and still have a large enough chunk of your stocks in liquid public positions.
If I had a lot of money, I'd put about 10% to 20% of my stock allocation into 2 to 3 different hedge funds that focused on private equity, and had steep liquidity restrictions. I'm talking if my portfolio overall exceeded $10M because then 20% of my stock portion is still only 5% of $10M so if I lost it all, I'd still have $9.5M. And hedge funds require huge initial investments, so I'd need a $10M total PP to make 5% of that total be worthwhile to a hedge fund manager.