How important is liquidity in your retirement portfolio?

Liquidity describes how quickly you can sell an asset and have access to the proceeds to deploy in another investment or hold in cash.

The liquidity spectrum starts at one day for most mutual funds and bonds. Stocks and exchange-traded funds have a three-day settlement period before you can access the money, but the securities can be sold on any business day. Some funds that invest in less-liquid investments offer liquidity on a quarterly basis or longer, sometimes even periods measured in years.

It seems obvious that we would all like our investments to have daily liquidity and quick access to our capital after selling one of our holdings. However, there is a price to pay for liquidity.

Perhaps one of the best examples of this cost is the significant outperformance of some of the large college endowment funds, in particular Yale and Harvard, compared to the average individual investor or funds employing the traditional stock and bond model. The endowment model, as it is referred to, emphasizes less-liquid investments including direct real estate, private equity, hedge funds, direct lending, timber and other asset types.

In fact, as of the last available annual report, the Yale endowment had only 5 percent allocated to U.S equities, about 15 percent in foreign equities and about 5 percent in traditional bonds. An endowment that has billions to invest and a mandate to survive forever is different from an individual investor who is planning for a 30-year retirement with portfolios typically ranging from hundreds of thousands of dollars to a few million.

The individual investor needs to keep a higher portion of the portfolio liquid to be prepared for life’s events. But perhaps there is a middle ground to utilize less-liquid investments for a portion of the portfolio to help reduce volatility risk and enhance return. Dedicating 10 percent to 30 percent of the portfolio to less-liquid alternative investments is enough to have an impact on the risk-return characteristics.

Why should we consider moving part of our portfolios to less-liquid securities? The reason is risk vs. reward.

Liquid investments in general offer lower yields or return potential than similar assets that have limited liquidity. This is why large endowments that value predictability of returns include less-liquid alternatives. In other words, you are usually rewarded with a higher return potential for giving up immediate access to your capital.

Another way to think about liquidity is to consider home or business ownership. Both homes and businesses are less-liquid investments that may take months or years to sell. But, for many of us, some of the best investments we have made from a rate-of-return perspective have been real estate or building our business.

I think investors should consider a diversified portfolio that includes an appropriate portion of alternative investments, some of which may be less liquid.

This story was originally published February 6, 2017 at 12:17 PM with the headline "How important is liquidity in your retirement portfolio?."