Liquidity Risk for Physical Assets

On 05/28/2010, in Investment Concepts, by Jordan Wilson

Previously we looked at liquidity risk for marketable securities. Stocks, bonds, and the like.

Today we shall review liquidity risk factors for physical assets.

I shall limit this to an overview only for two reasons. One, we will consider physical assets in greater detail when we look at the various asset classes. Two, investing in physical assets can be quite complicated and should only be considered by experienced investors. Therefore, it is out of scope for this investing series.

For purposes of this post, physical assets shall be those “hard” assets that you can physically hold in your hands. These include: real estate, gold, diamonds, arts, stamps and coins, wine.

We will alter the definition when we look at these assets in more detail. As we shall see then, often one can invest in these assets and never take actual possession. But for now, the term fulfils our needs.

Note that there are also “bankable” assets. These are assets held by your bank or brokerage house on your behalf. Rarely does one take physical possession, although it is possible to do so (but not usually prudent). These include cash, investment certificates, stocks, bonds, etc.

Physical assets tend to have many problems associated with them as investments. Liquidity being a large one. Here are a few things to consider.

How is the physical asset bought and sold?

Physical assets are significantly more difficult to trade than bankable assets.

Markets for trading may be non-existent or extremely inefficient. By inefficient, I mean that that any existing market does a poor job of: a) bringing the maximum number of buyers and sellers together; b) readily determining market value for the asset.

When there is no easy way to bring buyers and sellers together, trading suffers.

Perhaps you wish to buy your spouse a ring made from his May birthstone, an emerald. You know exactly the quality and size that you want. If you live in Toronto, your buying options may be limited. You can go to the local jewellery stores and pay the prices they offer for whatever inventory they may have on hand.

Meanwhile, Juan’s Jewellery in downtown Bogota, Colombia has exactly the ring you are seeking, but at one-third the price you must pay in Toronto. The price difference is due to a variety of factors – labor costs, transportation, import duty, and the fact that Colombia produces fine emeralds itself.

Unfortunately, unless you are in Bogota, it may be difficult to determine that Juan has much better deals than are possible in Toronto. This is because there is no formal market bringing buyers and sellers of emerald rings together from around the world. If there was, both you and Juan would benefit.

This tends to be a drawback for physical assets.

Even if a markets exist, the market itself takes a healthy share of the proceeds.

Consider the world of fine art investing.

Art transactions usually occur through dealers or auction houses. While commissions are often negotiable, an auction house may add 15-20% to the buyer’s price and receive a further 10% commission from the seller. This is financially dangerous if you want to trade quickly.

For example, you acquire a painting for $1.5 million. Sotheby’s, a major auction house, charges you $250,000 as a purchasing commission. One month later, you have a major financial crisis and need to sell the painting at auction.

The market is stable and you are able to find another buyer at the $1.5 million you paid. Unfortunately, Sotheby’s charges you a sales commission of $150,000 on the transaction.

While you bought and sold at the exact same price, you lost $400,000 (27%) on your investment. And that $400,000 loss did not factor in other costs associated with art trades, including: shipping, storage, insurance, marketing.

Sadly, in the real world of auction houses, the figures in my example are pretty accurate.

As a rule, the fewer options you have to trade, the more you will pay in commissions or fees.

While I used art as an example above, I could easily substitute stamps and coins, collectibles such as porcelain dolls or rare books; pretty much anything that can be bought and sold.

On the positive side, the internet and companies like eBay are improving the efficiency in trading physical assets. But that is a slow process.

How homogeneous is the asset?

Physical assets tend to be heterogeneous. That is, each individual asset is unique from others in its class. Obviously, the amount of uniqueness can vary greatly between assets.

As I wrote previously, randomly take 10, 1 carat diamonds and see how homogeneous they are in quality. There are likely significant differences between them that greatly impact their relative value.

Some items like gold, whether it be in bullion or coin form, is somewhat easier to evaluate. The keys being the gold content of the item and the current price of gold. If the asset is a coin, there might also be some consideration given to any numismatic value.

But what about the Mona Lisa painting? There is only one of this asset. How can it be compared to any other piece of art? Very difficult.

The less homogeneity, the more difficult the valuation.

Even for relatively homogeneous assets, each can differ in quality.

After watching the new Sex in the City movie, you realize that you need to buy a new 2011 E-Class Cabriolet. You go down to the local dealer, but there are none available. So, based solely on the movie and sales literature, you order one from the factory in Stuttgart, Germany.

Because it is a new vehicle, there is a high probability that every E-Class Cabriolet will be almost the same. Still, when it finally arrives, you will want to check it for scratches.

You also want to make certain that Gunter and his auto assemblers were alert the day your car was built. In rare cases, usually timed around German World Cup Football matches, mistakes are made and one or two “lemons” are created.

Time can also create differences between homogeneous assets.

In three years, when you attempt to sell the Cabriolet, potential owners will be more careful in their review than you were with the new vehicle.

Did you have an accident and replace the front end? Did you drive up and down the Autobahn everyday, putting 300,000 kilometers on the engine? Or did you simply drive it to and from the grocery store once a week and only have 5000 kilometers on it?

Review 100 2011 Cabriolets in three years and you will find a wide range of values for the cars.

What is the quantity of the physical asset?

Like financial instruments, the rarer the physical asset the less likely you can find a seller, although there may be many buyers available.

Also, with less assets in the market, there will be less trading. This leads to less publicly available information on recent pricing.

If Citigroup traded 622 million shares yesterday, that is a lot of shares trading hands. If you own 1000 shares, you should be able to sell them quickly with little impact on prices.

But how often are da Vinci or Renoir paintings bought and sold? Much less than 622 million times each day (or century).

How easy is it to value the physical asset?

The greater the volume of trades, the more information is available to potential traders as to the value of an asset at a given point in time.

The less trading, the less public information, the more expertise a trader requires to arrive at the proper value.

In trading 622 million shares today, Citigroup is relatively easy to value at its close of $3.96. And with the current bid of 375,000 shares at $3.94 and ask of 226,000 shares at $3.95, I have an strong sense of where Citigroup will open Monday (assuming no material news is released over the weekend that causes buyers and sellers to amend their bid-ask prices).

Remember that the volume of the bid and ask prices is as important as the actual prices themselves. Further note how tight the bid-ask spread is for this financial instrument. Based on the above information, and the fact that Citigroup has 30 billion shares outstanding, you can see it is a relatively extremely liquid asset.

If you wish to buy or sell a residential house, it is more difficult. You would examine “comparables” (or “comps”) to the property you are evaluating. While not an exact comparison, knowing the value of homes that have been recently sold that share similar characteristics with the property you are evaluating, greatly assists the valuation process.

Your information will definitely be less than 622 million home sales, but for many cities you can usually arrive at a decent valuation.

Now imagine living in a community where the last house was sold 30 years ago. Finding comparables to assess your property becomes extremely difficult. That is the case with fine art. One study found that the average time to market (from sale to next sale) is about 30 years. In some cases, 100 years is reasonable and some art never re-surfaces on the open market.

Expert knowledge of the physical asset is crucial.

To (hopefully) prosper in this investing realm requires an expertise in the specific asset.

If you are buying (or selling) a rare coin, you need to know at least as much as the person selling (or buying) it to you. Otherwise, you will be taken to the proverbial cleaners.

Again, the need for market specific expertise is necessary for all physical assets. Unless you have that expertise, I do not recommend directly investing in most physical assets.

That said, there are ways to indirectly invest in physical assets. As we shall see later, this can be beneficial to most investment portfolios. But that is a conversation for a later date.

For the moment, that concludes our look at physical assets.

And it also ends our discussion of liquidity and other nonsystematic risks.

Next, we will look at systematic risk factors.

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