Middle Class vs. Wealthy Investors – Liquidity

Behavioral finance is a field of study that melds psychology with finance to study human behavior and how it affects investment choices.

​​In the world of behavioral finance, we find that the middle class and the wealthy aren’t that far apart in their psychology – their vastly different approach.

The middle class and the wealthy start on their investment journeys with the same “rational” wants. They want to be financially independent – to have the resources to do what they want when they want and with whom they want. They strive for that financial independence because they diverge and why one class is stuck in the middle and the other has achieved their goals.

Basic behavioral finance says we are all irrational beings – swayed by biases that cause us to be impulsive and act irrationally.

​​Liquidity is a major catalyst in fueling impulsive and irrational investor behavior. Middle-class investors value liquidity because, in their “rational” minds, they believe that liquidity gives them control over their financial trajectory.  ​​

​​You might be asking yourself:  “What’s wrong with that?”

​​​​Don’t you want control over your finances? Not if it’s to your detriment, and studies and data show that investors don’t benefit from liquidity. The so-called “active investor” that values liquidity and that jumps in and out of stocks to take advantage of price movements and timing is not very successful. ​​Professionals who take an active investing approach are not successful either.

​​Over the past 20 years, the average retail investor has lost an annual average of .1% when factoring in inflation. Over the past 15 years, data shows that over 92% of investment professionals have failed to beat the market.

Investor behavior is often driven by biases that lead to unwise financial choices, and liquidity only enables this behavior.

​​Two of the major biases that affect investor behavior and are directly related to liquidity are availability and herding biases. Availability bias says investors will do what’s easy and available. For many, the convenience of a smartphone means getting the news and information in bits from social media and notifications.

​​Acting on readily available information is much easier and more convenient than doing actual research. Liquidity allows investors to act on these quick soundbites, news feeds, and notifications.

Closely related to availability is herding bias. When everyone is getting the same information, they all tend to react in the same way. Herding behavior is hardwired in our brains. There’s comfort in sticking with the herd, but the herd has historically gone astray in many instances. Once again, liquidity plays a big part in herd behavior.

Are the wealthy immune from behavioral biases? No, but they recognize these biases and have figured out how to neutralize them to protect them from themselves.

​​Without a doubt, the #1 neutralizer of portfolio-destroying biases is illiquidity. Illiquidity protects investors from themselves – preventing them from acting on their impulses triggered by availability and herding biases.

Whereas the middle-class need/want liquidity and are drawn to liquid investments such as stocks, bonds, and crypto, wealthy investors avoid liquidity. They know better.

​​As I shared with you in the following article, wealthy investors prefer certain illiquid investments:  https://ftwinvestmentsllc.com/how-much-of-your-portfolio-should-be-in-real-estate/

The wealthy favor the illiquid private investments are commercial real estate and private equity with no public markets and long lockup periods.

​​This illiquidity not only protects investors from themselves but also from other investors.

I touched on availability bias earlier and how investors tend to do what’s easy and convenient, and many find convenience in financial advisors. What’s easier than letting someone else do the work for you?

It should come as no surprise that financial advisors are big champions of liquidity. Why?

Commissions. Transaction-based commissions incentivize financial advisors to churn their clients’ accounts. Liquidity promotes this behavior, and it’s why advisors steer their clients to the public markets.

Control. Long-term investments like CRE and private equity take investment choices out of an advisor’s hands. Instead of making daily investment decisions, CRE and private equity relegate advisors to making decisions on a timeline based on years and not seconds or hours. It’s why their overlords and underwriters discourage private investments.

Look Busy. Liquidity and churning make advisors appear to be busy. When you receive a monthly statement showing your trading activity, heavy trade volume makes the advisors look like they’re working hard to earn their money. Savvy investors know better, but advisors have been doing this for decades, so it must be working.

Passing the Buck. If the market takes a downturn, advisors can blame the broader economy or other investors. They can blame liquidity for their clients’ woes explaining that they can’t control other investors liquidating their positions and dragging prices and the market down in general.

The middle class and the wealthy share the same dreams. They all want financial independence and to be able to spend more time with their loved ones and do more of the things that bring them joy.

The middle class and the wealthy also share the same impulses. The wealthy know how to suppress those impulses better. By turning to illiquid assets, the wealthy eliminate biases and irrationality from the investing equation.

By taking a hands-off approach to investing, they not only free up time to do other things, but they also allow their investments to germinate, blossom, and flourish.


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Logan Freeman

Building generational wealth with alternative investments