By Lance Helfert

You may know the old aphorism that "all signs of rain fail in dry weather." The concept applies to finance as well as precipitation. For investors, liquidity refers to the ease with which you can access cash from your investments. How fast can you get out of a stock if you need to sell it? Usually there is a fairly rational market, and when heavy selling pressures a stock price, ready buyers pick up the shares on the cheap and maintain market equilibrium. But liquidity is not guaranteed, and prices drop quickly when people cannot find buyers - regardless of the company's underlying value.  

When prices are dropping rapidly, buyers retreat to wait for the bottom, or become reluctant to buy something they may be unable to sell. When nobody is buying, liquidity disappears. This proves extra harmful to small cap companies, which feel a disproportionate impact compared to companies with massive market caps.

For most long-term investors, a temporary loss of liquidity isn't too much of a problem. By temporary, we do not necessarily mean "short-term." Even a long-term illiquid investment presents little trouble for someone with liquidity elsewhere. The market historically shows tremendous resilience, and those who can ride out the storm for a few years need not turn temporary losses into permanent ones by selling during a liquidity panic.

Money managers, on the other hand, face a more serious challenge during times of constrained liquidity. When everyone is selling regardless of price or underlying value, managers may be compelled by clients or leverage or other pressures to sell securities they would prefer to keep. Some managers contract with their clients for discretion to manage funds as they see fit, but all managers must ultimately obey the wishes of clients unless they have lock-ups, as do most hedge funds. Groups that manage a lot of money may be MORE susceptible to panic selling than individuals, turning the perception of a price crash into reality. Satisfying client demands for redemption can cause prices to drop further, creating a vicious cycle of panic selling.

For individuals, Wall Street panics affect investors differently depending on their goals and timeframes. A sixty-year-old with a thirty-year-old 401(k) and a twenty-year-old with a brand new IRA find themselves in completely different situations right now. The elder may have lost 50% or more of his nest egg in the last year, whereas the new investor has lost little and been presented with rare bargains and an opportunity for significant future appreciation. Liquidity means little to the twenty-year-old, and can mean everything to the investor approaching retirement.

For both individuals and managers, illiquidity reduces our agility when better opportunities present themselves and we cannot capitalize on them. But illiquid investments are typically cheaper because they reflect a liquidity discount, and are often attractive to value investors as part of a broader portfolio. So liquidity can be a double-edged sword, but the financial meltdown of 2007-2008 reminds us to better respect both sides of the blade. 

Lance Helfert is co-founder and president of West Coast Asset Management, and a co-author of The Entrepreneurial Investor: The Art, Science and Business of Value Investing. This blog entry is an excerpt from West Coast Asset Management's monthly newsletter, Exclusive Outlook.