Weigh the Downsides of Tying Up Your Money

You need a superior return on any investment that ties up your money for years.

— -- Suppose someone approached you and said, “If you buy the investment I have in mind for you, you can get good returns — but you won’t be able to access your money for 10 years without a substantial penalty.”

And then what if someone else said to you, “I can get you the same returns on your investment, and you can access your money, cashing it in at any time without a penalty; you’ll get the returns earned to date.”

Suppose you found out that the returns from the investment that ties up your money for a decade aren’t likely to be as good as those from the second proposition.

What would you do? Of course, you’d forget about the first proposition, right? Why would you tie up your money just to suffer lower returns? If anything, you need higher returns to justify the lack of access.

Investments that you have ready access to — without penalty — are known as liquid investments, and those that tie up your money for a quarter, a year or even a decade and impose significant penalties for cashing them in are illiquid investments.

Most of the standard investments you’re familiar with are the liquid variety. These include stocks, bonds, savings accounts, money market accounts and shares of mutual funds and exchange-traded funds (ETFs) for any of various forms of underlying investments (stocks, various types of bonds and commodities).

Illiquid investments include many types of investments you probably aren’t as familiar with. Among them are different forms of annuities, venture capital and private equity funds, hedge funds and private real estate investment trusts.

Regardless of how good an investment an illiquid item may seem, you must weigh these advantages against the opportunity costs of having your money tied up. The key questions to ask are: Can I get a better returns? Does this investment create diversification so that when the market zigs, this investment zags? Suppose you tie up a large chunk of your accumulated assets in an investment that will hold on to this money like a Gila monster for 10 years (unless you want to pay a whopping 10 percent penalty — which defeats the purpose of investing in the first place). Then suppose the house in the country you want as your vacation/retirement home becomes available at a foreclosure sale for a fraction of its actual value.

To be compensated for damage from lost opportunity, you need a reasonable assurance of stellar returns from your illiquid investment. The problem is that the prospects of such returns from these investments sometimes aren’t good and, in many cases, are unknowable.

With an annuity, at least, you know exactly what you’ll be getting. Various studies have shown that you can do better long-term by investing this money in liquid investments. But many investors like the certainty of a guaranteed income stream of a set minimum amount. Many annuity investors like the illiquidity of these investments because it bars their access to money that they might otherwise spend.

By contrast, with venture capital, private equity and hedge funds, there are no guaranteed returns. These investments can have long lockup periods with surrender charges for anyone who wants to get at their capital earlier.

Lockup periods for hedge funds aren’t as long, but net returns are challenged by the high fees charged by fund managers. Some of these funds may be a good idea for some investors, depending on their risk tolerance and their goals and on the capacity of the fund to increase when the stock market declines— but the lockup is a certainty.

Another illiquid investment is a private real estate investment trust — a pooled investment for buying, holding and sometimes managing commercial or multi-family residential property. When you buy shares in private REITs, your money could be tied up for long periods. Yet the same type of investment is available in publicly traded form. With these products, you can track values day to day and get out anytime you like.

Many illiquid investments are marketed primarily to people of considerable means, and this is perhaps as it should be. You need substantial assets to closet a big chunk of money away for years. This way, you retain flexibility to take advantage of opportunities.

The marketing of illiquid investments can be intense. As the salesman touts these investments’ supposed advantages, interrupt him or her and ask an important question: What do you get out of this? If they don’t want to talk about it, you may want to end the conversation. Full disclosure should include the motivation to sell.

If you decide to buy illiquid, depending on what you’re buying, you might want to have a going-away party for your money; you may not see it again for a long time. And when your money comes home, you want it to bring along enough friends to justify the wait.

Any opinions expressed here are those of the columnists and not of ABC News.

Jamie Cornehlsen Ted Schwartz are advisors with Capstone Investment Financial Group in Colorado Springs, Colo. Cornehlsen is also president of Dunn Warren Investment Advisors in Greenwood Village, Colo. A Certified Financial Planner®, Schwartz advises individuals and endowments. He holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com. Cornehlsen, a Chartered Financial Analyst®, advises business owners and employees on retirement plans. He holds a B.A. from the University of Colorado and an M.B.A. from the William E. Simon School of Business at the University of Rochester. He can be reached at jcornehlsen@capstoneinvest.com.