Liquidity Preference: Why Rational Investors Settle for Lower Returns

Cash has no interest, and typically depreciates due to inflation while it is being held. Cash is still held by trillions of dollars, even though savings accounts, stocks, and bonds usually offer better returns. John Maynard Keynes proposed an explanation for this in 1936. He explained that liquidity has intrinsic value (liquidity preference theory). The reasons for holding cash can be grouped into three different motives: (1) the Transactions Motive - needing cash for daily transactions, (2) the Precautionary Motive - having cash as a “cushion” in the event of anything unexpected, and (3) the Speculative Motive - being in a flexible position to take advantage of a good opportunity, or get out of a bad one. It is not necessary for these motives to pay interest on the duration of cash held; holders must have access to it when needed.

Once liquidity is accepted as having intrinsic value, everything else follows logically from that condition. Cash and near-cash equivalents are inexpensive to transfer, have a short conversion time, and do not require liquidating illiquid assets at the worst possible time when cash is urgently needed. This is essentially the same concept as the risk-return tradeoff that is covered in introductory finance courses. Because of the inability to liquidate or access a long-term bond, real estate, private equity, etc., the asset must provide a greater return to entice the potential investor. This return is referred to as the “liquidity premium”. Flipping the idea around, this theory explains why liquid assets are able to pay a lower return. The holder is not only purchasing a return on their investment; they are purchasing an option on the return.

There also exists a temporal dimension to liquidity preference theory. According to intertemporal choice theory, each saver makes comparisons between money today and money in the future. The rates at which a saver compares money today to money in the future are dependent on the saver’s personal discount rate at the time. A saver with a high preference for money today will likely keep their wealth in liquid form regardless of the anticipated return being earned. A saver who is more patient and confident that they will not need their money in the near term will likely keep their wealth in less liquid and more advantageous investments. The uncertainty associated with the future increases all savers’ personal discount rates; therefore, the value of having the ability to act quickly is heightened as the future becomes more uncertain.

Currently, we can see how the current volatility in the markets has caused people to invest their money into US money-market funds rather than riskier investments, resulting in an increase of nearly $66 billion in only one week. When investors feel they cannot rely on the stock market or US Treasuries for their investments, they tend to migrate their cash to the closest alternative, which usually means they prefer cash-like holdings. What is interesting, however, is that many investors have found themselves continuing to migrate to US Treasuries while simultaneously investing funds in money-market funds for their short-term cash needs. This demonstrates that the inclination towards liquidity is a factor in making both US Treasuries and money-market funds attractive, independent of yield.

At the same time, this pattern is becoming more widely accepted by many institutional investors. For instance, large corporations' treasurers, pension funds and fiduciaries now utilise money-market funds as a part of their regular liquidity management processes rather than simply as a speculative investment. In addition, while the majority of individual retail investors hold approximately $3.07 trillion of total money-market fund balances, institutional investors hold nearly $4.57 trillion, collectively. Most corporate treasury departments are not investing their payroll funds in an effort to maximise returns. Instead, they want to guarantee that their employees' wages will be there on payday, so they value certainty over maximum return.

This situation can also be seen within the technology industry, including how people research the best XRP wallets to determine the ideal way to store their cryptocurrency. For example, a hot wallet sacrifices some security (from being online) and offers quicker access to funds, while cold wallets sacrifice speed and ease of accessibility to store funds without needing an internet connection. While both options are valid based upon one’s individual needs, they come from different parts of the same liquidity/risk continuum that Keynes used when discussing the relationship between cash and bonds.

By looking through a broader lens, the ramifications of the liquidity preference phenomenon extend well beyond individual portfolios. In fact, Keynes used the liquidity preference phenomenon to explain how the interest rates are determined, because the rates are established by how much cash (money) the public wishes to hold versus how much is available at that particular point in time. Whenever liquidity preference increases during times of uncertainty, which is often referred to as a “flight to safety”, the impact of lowering interest rates is reduced since people will continue to “hoard” cash at all possible levels of interest rates. This liquidity preference also determines how banks set their borrowing costs, how corporations price their long-term debt and how all families, as a whole, allocate their funds between immediate needs and future growth.