When choosing an investment strategy, liquidity should be an integral component of the decision-making process and a cornerstone of a portfolio’s asset allocation.And yet, despite the importance of being able to convert your assets to cash when needed, most widely advertised investment strategies seem to downplay the concept of ‘liquidity risk’ leaving investors to sort through this critical factor on their own.Unfortunately, in recent years it took the dramatic downturn in real estate prices and freezing up of credit-related markets during the Great Recession of 2008 and 2009 for many to realise the importance of being able to convert to cash easily when things go south. One of the important lessons from those trying days is that liquidity is generally not important until it is important!However, even in these supposedly better times, property owners in both America and Bermuda are frequently caught short of cash, often finding themselves ‘property rich’ on paper but cash poor as rents decline in key markets, sudden vacancies occur, and property buyers remain scarce.Individual parcels of land and small businesses are widely known to be very illiquid but even other common assets normally traded frequently and in big volumes have had bumps in the road.For example, during the depths of the ‘Great Recession’, supposed liquid mortgage-backed securities, including Collateralised Mortgage Obligations (CMO’s) and Collateralised Debt Obligations (CDO’s) saw bids dry up as the world’s largest broker-dealers refused to bid across entire classes of securities.Defining and measuring liquidityAn academic paper published in 2006 by Norwegian economist, Kolja Loebnitz, explored the importance of liquidity with respect to investment strategy and defined liquidity as “the discounted expected price concession required for an immediate transformation of an asset into cash or cash into an asset under a specific trading strategy.”The paper went on to make the point that all assets have the potential to suffer a liquidity crunch if enough sellers enter the market at the same time, making a pure definition of liquidity somewhat fuzzy. Nevertheless, certain basic rules exist which allow investors at least some comfort in measuring liquidity risk.Before evaluating the various asset classes and their levels of liquidity, it is important to note that within broad asset classes, individual securities or assets may possess widely varying levels of liquidity.For example within the general class of ‘common stock’, IBM Corporation trades over three million shares each day on the New York Stock Exchange while other listed stocks hardly trade at all.Stocks in smaller companies or which have fewer shares outstanding, such as most of those listed on the local Bermuda Stock Exchange (BSX) trade very infrequently. For example, last Monday Butterfield Bank, one of the largest BSX constituents, traded only 1,300 shares on the day. If an investor wishes to sell a large position of Butterfield stock they may have to wait a week or even a month or more to find buyers at the right level. Therefore, the first item to consider in evaluating liquidity is the amount of volume which a particular security reports daily on its relevant exchange. Generally, the higher the volume, the better the liquidity and the less of a chance that the friction costs of trading eat away at the investor’s realised return.One yard stick which I like to use is a calculation of the total cost to buy and sell a security on the same day at the same point in time. For most listed securities the best starting point for this calculation is the bid-ask spread.For example, if an over-the-counter stock for is bid $9.50 (the price at which a security may be sold) and asked (the price at which the security may be bought) $10.00, then the bid-ask spread is $0.50 or five percent off the offered price. For this security, a buyer must pay $10.00 to purchase the stock but will receive only $9.50 if he needs to sell the stock right then. Importantly, the stock in this instance must appreciate by at least five percent for the investor to break even on the investment. Of course, the buyer must also factor in any additional broker or exchange fees on both the buy and sell side of the transaction.Liquidity of different asset classesOne of the more famous studies of liquidity was submitted by the economist John Exter in the early 1970s who presented a pyramid of liquidity ranking the most popular assets classes from the least to the most liquid. At the top of the pyramid (least liquid) were small businesses, real estate and precious gems. After that, the study pronounced liquidity to be progressively better in the order of OTC stocks, commodities, municipal bonds, corporate bonds, listed stocks, government bonds, Treasury Bills and then Fed Reserve Notes.Surprisingly, Mr Exter placed gold at the bottom as the most liquid asset. Then, as perhaps now there was a concern about the true value of paper money and gold was considered to possess an intrinsic, tangible value.Overall, I would agree with his ranking system with the exception of that commodities have become increasingly liquid through the futures markets and the advent of Exchange-Traded Funds (ETF’s). Also, I would reverse the order of corporate and municipal bonds as corporate bonds are generally more liquid these days than most municipal bonds. Over the past few decades, we have seen a massive number of new municipal bond issues come to market while at the same time all of the major municipal bond insurance companies virtually disappeared.And finally, while gold retains its lustre as a store of value and has even grown in popularity, I have a hard time believing gold to be an extremely liquid investment. Practically speaking, liquidity in physical gold is hampered by storage and transaction costs which are still relatively high compared to the predominantly electronic world of traditional marketable securities.Cashing inTools such as the liquidity pyramid and analysing public trading volumes and spreads are helpful in pulling to together a useful framework for constructing and monitoring a success investment portfolio. Just as important, however, is putting in the extra work towards identifying the timing and amount of potential cash requirements needed from a portfolio and having a general sense of risk tolerance. Over the years, I have heard too many sad stories of clients needing cash on short notice and being forced to liquidate securities quickly at a time when markets were on the downswing. In many cases, proper advance planning would have produced much better results. A better plan is to build a portfolio with careful attention to client investment objectives and portfolio liquidity.Bryan Dooley, CFA is a portfolio manager at LOM Asset Management in Bermuda specialising in the areas of portfolio management, investment strategy and quantitative process. He possesses an MBA from the College of William and Mary and has held key positions with progressive financial institutions worldwide throughout a career spanning more than 20 years. He can be contacted at 441-294-7032 or bryan.dooley[AT]lom.com.This article is for information purposes only and is not investment or financial product advice and is not intended to be used as the basis for making an investment decision. The information has been compiled from sources believed to be reliable however Lines Overseas Management Limited nor any of its affiliates or representatives makes no representation or warranty, express or implied, as to the fairness, accuracy, completeness or correctness of the information, opinions and conclusions contained herein.