The word "liquidity" gets bandied about quite a lot, but it is surprising how many portfolio managers take a naïve approach to liquidity. It is well known that one should be compensated for investing in less liquid instruments (liquidity premium), but how much? What is the value of liquidity?

It is dangerous in merely trust one's intuition on the value of liquidity. Consider the following one-person game: 

The "Balls in the Hat Game"

The game consists of a hat that contains 6 black balls and 4 white balls. The player picks balls from the hat and gains $1 for each white ball, and loses $1 for each black ball.  The selection is done without replacement. At the end of each pick, the player may choose to stop or continue. The player has the right to refuse to play (i.e. not pick any balls at all). Given these rules, and a hat containing 6 black balls and 4 white balls, would you play? (Why?)

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