“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.”
-Keynes
What will be the biggest risk for 2015? It will be liquidity. There will be more one-sided risks based on any significant changes in beliefs, but these shifts will be heightened because liquidity will be missing. There will not be any dealers standing on the other side of the market. So should investors pay a premium just to have liquidity? The answer is no, but shifting to less liquid markets is not going to be a solution either. Investors just have to work under the assumption that liquidity will not be present at the most critical times and the Fed may not have the tools to solve the problem.
I am in the liquid alternative space, so do I have a fetish for liquidity? I just know that liquidity will be scarce when you need it so you better plan for every exit. That does not mean that you have to have stop-losses on every trade. Markets can easily blow through stops so it can provide a false sense of security. The only ways to really protect against a liquidity crisis is through diversification and limiting leverage. Diversification is simple - never place too much in any trade and assume that correlations will go up in a crisis. Leverage is also straight-forward - do not use too much leverage no matter what is the return to risk.
Everyone cannot have liquidity, so it is critical to monitor markets for reversals. If trends change, the response has to be swift and without hesitation. Cut or reverse positions. Use the liquidity first because there may not be much behind it in the short-run.
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