18 Pages Posted: 9 Aug 2006
Date Written: May 2006
Assets are economically liquid when they can be sold quickly with no loss relative to their fair market value. Assets are "mentally liquid" when they offer investors options to obscure losses relative to reference prices and options to avoid their realization. Purchase prices are common references prices but other prices, such as the maximum price reached during the preceding 12 months, might serve as reference price. The price of a 20-year $1,000 Treasury bond purchased for $1,000 a year ago might have declined to $900 because interest rates increased during the year. That bond is almost perfectly economically liquid; investors can sell it for $900 less a small commission. But the mental liquidity of the bond is impaired if investors are unable to avoid observation of paper losses relative to the purchase price or if they feel compelled to postpone the sale of the bond so as to avoid the realization of losses. Still, the bond is more highly mentally liquid than a stock since bondholders have the option to wait till maturity date and avoid the realization of losses while stockholders do not have that option.
Investors like gains and hate losses so they love investments that combine the prospect of gains with protection from losses. The purpose of this article is to describe some of these investments, highlighting the features designed to obscure losses or avoid their realization. These securities include bonds, money market funds, stable value funds and indexed annuities.
Keywords: liquidity, behavioral finance, bonds, bond ladders, disposition effect
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation