Too much liquidity can enable irrational behavior among clients. (Illustration: Lonnie Busch/Theispot.com)

The evidence is fairly clear that humans (and that category includes most investors) tend to make economic decisions that are not in their best interest. Liquidity, as it turns out, can enable this irrational behavior.

Behavioral finance is a young science that uses psychology to understand irrational thinking. It’s not just social scientists who are poring over evidence of our irrational behavior, though. DALBAR has been studying money flows in and out of mutual funds for 30 years and concludes that investors can be their own worst enemy. They tend to make bad decisions at critical points, in both up and down markets. The worst case was October 2008, when equity investors lost 24.21% while the S&P 500 Index lost 16.8%.

That brings me back to the subject of liquidity. The ability to convert any asset into cash immediately and easily sounds like a perfect goal for investors. In 2008, the opposite happened as liquidity decreased for every asset except cash and short-term Treasury bills. The experience was not easily forgotten. In fact, behavioral finance tells us that investors remember losses more vividly than gains, even if their gains are greater. Investors reasonably concluded that step one in avoiding similar losses required staying liquid.

It’s no surprise, then, that liquid alternative mutual funds experienced a 22% annual growth in assets (excluding commodity funds) between 2010 and 2014 versus 12% for the mutual fund industry overall. Investors were looking for potentially higher risk-adjusted returns, but they had to include liquidity.

However, the liquidity “trap” comes at a cost. The ease with which the average mutual fund investor can buy and sell securities is not always an advantage.

Does that mean investors should protect themselves from themselves by allocating assets to illiquid investments? It’s a question more will be asking as private equity, considered one of the least liquid of investment alternatives, makes its way to the retail market.

Private Equity Less Exclusive

Traditionally, private equity has been available to institutional or high-net-worth investors — accredited investors — who could meet the high minimums and afford to lock up a portion of their assets for years. Private equity mutual funds now coming to market (full disclosure: Altegris offers one) give a broader group of investors access to this asset class with characteristics similar to mutual funds — but, importantly, without daily liquidity. Thus managers of these private equity funds can ignore the market’s demand for instant performance and untimely withdrawals. They can focus on investments that take more time and potentially more effort to work.

Of course, private equity funds haven’t marketed themselves as a safeguard against irrational behavior. It’s their track record that has attracted university endowments, foundations, pension funds and wealthy investors. To wit, in the 25 years through September 2015, the Cambridge U.S. Private Equity Index returned 13.4% annually compared with 9.9% for the S&P 500 Index, according to Cambridge Associates.

We passed the seven-year anniversary of the bull market in March, making this the third longest rally in history. When the rally ends, behavioral finance studies suggest many investors, trapped in their irrationality by the ability to sell, will sell at the bottom and fail to get back in as the market recovers. We have already seen that in the increased volatility experienced over the last 12 months. Illiquidity in private equity funds might prevent them from doing just that.

This requires a close look at one’s liquidity requirements. That 3.5% illiquidity premium measured by the performance of the Cambridge Associates Index versus the S&P 500 can compound into some large numbers for a child’s education or a different kind of retirement.

Of course, past performance is no guarantee of future results. This applies to liquid and illiquid markets. Odds are that we are in for a five- to 10-year period of a “Warren Buffett market,” with lower GDP results, lower equity returns and greater dispersion. As Buffett recently observed, investors should be wary any time the market value exceeds the value of GDP.

With a potentially lower return from the traditional markets, meeting an investor’s financial goals today requires a fresh look at allocations and some real discussions about the liquidity trap.

— Read “SEC to Discuss Accredited Investor Definition, Reg D Offerings” on ThinkAdvisor.