What investors should know about liquidity risk

— Originally published as Investor Insights newsletter May 2025

While this month’s topic might sound a bit wonky, liquidity is an important concept for every investor to understand. Investors may be rewarded for their patience and willingness to forgo immediate access to their money. But it has to be done thoughtfully — giving it up at the right time and for the right investments. As always, please let us know what you think by hitting the feedback button at the end of this email.

Winners, drawers, and losers

Winner: Unflappable investors

Only a month after tariffs sent markets into bear territory, those losses have largely been erased, rewarding investors who held on.

Drawer: Canada’s EV industry

New facilities from Stellantis and VW are still on track, but Honda, GM, and Northvolt have canceled, reduced, or delayed production plans.

Loser: Flappable investors

Volatility is a normal part of markets. Tuning it out should be, too.

Investing 201: What is liquidity risk — and how can it benefit you?

Most investors know that you have to take on risk in order to generate significant market returns. That’s why the general advice has always been to build your portfolio based on the amount of risk you’re comfortable with and how much of it you need to reach your goals.

But what many investors don’t know is that price volatility isn’t the only kind of risk. There’s also liquidity risk, or the risk that comes with giving up access to your money (aka its liquidity) if a better option comes along. As with most types of risk, the potential for reward increases when you take on liquidity risk. Although it’s not right for everyone (more on that below), liquidity risk can increase your returns in asset markets, and it’s diversifying to many portfolios, since most investors are exposed only to price risk.

Liquidity risk can also insulate investors from market turbulence like we saw last month, since it can be easier to ignore the ups and downs of the stock market when you know a portion of your money is locked in and earning a higher return.

Taking on liquidity risk earns you something called an illiquidity premium — the additional return a borrower pays in order to guarantee their financing for longer. For example, if a company were building a large, capital-intensive, five-year project, it would pay investors more to loan it money for the full period, rather than try to refinance the debt every year. This concept becomes even more useful when investing in a diversified pool of loans that will mature over time, and you won’t need to wait the entire five years to see cash flow from maturing assets.

You’ll see illiquidity premiums in some common types of investments, like unbreakable GICs: the longer the term of the investment, the higher your interest rate tends to be. Somewhat confusingly, however, there is no illiquidity premium into long-term bonds. That’s because of something called securitization. This process, generally run by big banks, turns loans you would typically hold to maturity into tradable bonds. Those big banks collect a fee, reducing the liquidity premium in the private loan to the standard market return on a daily liquid bond security.

The most common source of illiquidity premiums is alternative assets like private credit, private equity, real estate, venture capital, and infrastructure funds. Why? With private credit, companies are willing to pay more to get their money quickly and with fewer terms. In the case of private equity, those premiums are worth it to companies who wish to stay private for longer, allowing them to focus on maximizing long-term growth rather than satisfying investors and reacting to stock prices.

How to decide if illiquid assets are right for you (and where to hold them if they are)

Liquidity risk isn’t appropriate for all investors.

If you’re saving for short- or medium-term goals, such as a home purchase in a few years or a wedding, investing in illiquid assets puts you at risk of not being able to get your money back in time — and that is not worth any benefit those illiquid assets may hold.

But if you are saving toward a retirement that’s more than 10 years away, locking up a portion of your money for a longer period offers the potential of higher and more consistent returns. Adding a 20% allocation to alternatives in a portfolio could increase its expected return by 0.4% - 0.5% per year. That may not sound like much, but it is enough to potentially grow the funds available at retirement by about 15% over a 30-year period. That translates to more money to spend on pickleball, travel, and spoiling any grandkids you may have.

As for where to hold illiquid assets, RRSPs are often the best option because they offer tax savings on your returns. Because you lose a lot of those tax benefits when you make early withdrawals, this can be a good way to force yourself to leave your longer-term investments alone. If you’re interested in learning more, reach out to an advisor.

Client question of the month: How would someone divest from U.S. assets?

With the recent changes in America's trade policy and the growing push to buy Canadian, some version of this question has come up from clients with surprising frequency lately. How to interpret and respond to international politics is, of course, a very personal decision. But if you are considering moving your investments away from a particular region for any reason, there are a few things to consider.

In recent years, the question was often the opposite: why invest anywhere but the U.S., given its strong relative performance? The answer then was the same as it is now. Geographic diversification is essential. Every portfolio has a range of potential outcomes, and the more concentrated you are in a specific region, the wider that potential range becomes. By investing in markets across multiple countries, you can help smooth out volatility, protect against region-specific downturns, and improve expected returns over time.

If you do want to reduce or completely avoid U.S. exposure, be cautious of simply doubling down on the Canadian market. That exposes you to risks that could otherwise be diversified away, like being concentrated in specific sectors and smaller groups of securities. (Research suggests you can allocate up to 30% of your portfolio to your domestic stock market before seeing negative effects.) Instead, it can be wise to reallocate across a broader mix of countries to build a more resilient portfolio.

Great reads 📖

Buffett’s Bet of the Century: Buffett, his legacy, and how he helped inspire a generation of index fund investors.

Instead of getting paid for Illiquidity, should investors pay for it?: Illiquid investments offer real benefits — enough that some people argue they should come at a price.

What are alternative investments: Get to know more about this investment class and whether or not it may make sense in your portfolio.