In today’s investment landscape, portfolio diversification extends beyond traditional stocks and bonds. Many investors overlook the potential benefits of adding illiquid assets in private markets to their financial strategy. These investments, which cannot be quickly converted to cash without potential loss of value, offer unique advantages worth considering.
Illiquid assets can help diversify your portfolio away from systemic market risk while potentially providing higher returns with an “illiquidity premium.” While these investments require longer holding periods and careful planning for your cash flow needs, they can serve as ballast during market turbulence. From private equity to real estate, understanding how illiquid investments complement your liquid holdings may significantly enhance your long-term investment outcomes.
1) Illiquid Assets Provide Diversification Against Systematic Risk
Systematic risk affects the entire market, making it difficult to avoid through traditional stock diversification alone. When you include illiquid assets in your portfolio, you gain exposure to investment types that often move independently from public markets.
These assets can help you build a “moat” against market volatility. During periods when stocks and bonds decline simultaneously, certain illiquid investments may remain stable or even appreciate in value.
Effective diversification involves including assets with different risk-return profiles and market correlations. Illiquid investments like private credit, private equity, or infrastructure projects typically have lower correlation to public equities than their public market counterparts.
You can potentially reduce the overall volatility of your portfolio by combining liquid and illiquid assets. This approach creates a more balanced risk exposure across different economic conditions and market cycles.
The diversification benefit is particularly valuable during market crises when correlations between traditional assets often increase. Illiquid assets may help preserve capital during these periods because they’re not subject to the same panic-driven selling pressures.
Assets that perform differently under various economic conditions can offset each other’s weaknesses. For instance, private credit can hold its par value even when public bonds fall in value due to rising interest rates.
I liked High Yield Harry’s post due to the market volatility on March 4th and it’s what prompted this blog post.
2) Potential for Higher Long-Term Returns
Illiquid investments often command what is called an “illiquidity premium.” This premium represents the additional return investors can expect as compensation for accepting limited liquidity access to their capital. Long-term investors with adequate cash reserves elsewhere can capitalize on this premium. If you don’t need immediate access to certain portions of your investment capital, you can potentially benefit from these higher expected returns while other investors cannot.
The characteristics of illiquid private assets offer potential for higher overall expected returns compared to their liquid counterparts. When you lock up your money for extended periods, asset managers can pursue investment strategies that may be more profitable over time.
Illiquid assets typically remain more stable over time since their pricing isn’t adjusted daily like publicly traded stocks. This pricing stability allows investment managers to make decisions based on long-term value rather than short-term market fluctuations. Without pressure to deliver quarterly results or manage daily liquidity needs, managers of illiquid investments can capitalize on opportunities that might be overlooked in public markets. This patient capital approach often translates to enhanced returns.
Private market assets frequently outperform public market equivalents over extended time horizons. Your willingness to accept illiquidity can be rewarded through access to these potentially higher-yielding asset classes. The compounding effect of even slightly higher returns can significantly impact your portfolio value over decades. An additional 1-2% annual return from illiquid investments may substantially increase your wealth over a 20-30 year investment horizon.
3) Illiquid Assets Have Lower Correlation with Stock Market
One of the most significant advantages of illiquid assets is their tendency to have a relatively low correlation to the stock market. This means when public markets experience volatility or downturns, your illiquid investments may not follow the same pattern.
This diversification benefit can be crucial during economic uncertainty. When stocks plummet, illiquid assets often maintain their value or decline less dramatically, providing stability to your overall portfolio performance.
The lower day-to-day volatility of illiquid investments contributes to this reduced correlation. Without constant mark-to-market pricing, these assets aren’t subject to the same emotional trading patterns and algorithmic selling that can amplify market swings.
By including illiquid assets in your portfolio, you can diversify away from market risks that affect most public market investments simultaneously. This creates a protective buffer against market-wide shocks that might otherwise impact your entire investment strategy.
The structural differences between liquid and illiquid markets create this beneficial correlation divergence. While public markets can overreact to short-term news, illiquid investments only reflect fundamental value based on cash flows and long-term prospects.