CHAPTER 14
The Value of Liquidity
Whenyou buy a stock, bond, real asset, or business, you
sometimesfacebuyer’sremorse,whereyouwanttoreverse
your decision and sell what you just bought. The cost of
illiquidityisthecostofthisremorse.Inthecaseofpublicly
tradedstockinaheavilytradedcompany,thiscostshouldbe
small.Itwillbelargerforstockinasmall,over-the-counter
stockandwillescalateforaprivatebusiness,wherethereare
relativelyfewpotentialbuyers.Itcanalsovaryfordifferent
types ofassets,with highercostsforrealassets andlower
costs for financial assets. In this chapter, we examine the
reasons why investors value liquidity and the empirical
evidence on how much they value it. We follow up by
looking athow theperceived liquidityor illiquidity of an
assetaffectsthepriceyouwouldbewillingtopayforitand
how best to incorporate illiquidity into valuations.
MEASURING ILLIQUIDITY
Youcansellanyasset,nomatterhowilliquiditisperceived
to be, if you are willing to accept a lower price for it.
Consequently,weshouldnotcategorizeassetsintoliquidand
illiquidassetsbutallowforacontinuumonliquidity,where
allassetsareilliquidbutthedegreeofilliquidityvariesacross
them.Onewayofcapturingthecostofilliquidityisthrough
transactions costs, with less liquid assets bearing higher
transactions costs (as a percent of asset value) than more
liquidassets.Inthissection,weconsiderthecomponentsof