Liquidity In Finance
Liquidity In Finance: What You Need to Know
To be a wise and savvy investor, it’s important to have a full understanding of a few key concepts - like the idea behind liquidity. What does the term “liquid assets'' mean? What is an example of liquidity?
We’re discussing all of it here, along with some pros and cons of both liquidity and illiquidity, so you can be confident in your understanding of these important parts of having a solid, well-rounded, balanced portfolio and investment strategy.
What is Liquidity
Liquidity is the amount of cash you have readily available and accessible to meet financial responsibilities like spending or investing. It’s always a good idea to have an appropriate level of liquidity available for a rainy day fund so you’re prepared for anything that may pop up, especially those unexpected expenses in life.
In the world of investments, liquid assets are those that can easily convert into cash with little to no effect on market price. It can be easiest to think about liquidity as how much money you could quickly get from an asset.
Example of Liquidity
If a person, institution or company has high liquidity, they have enough assets and cash flow to easily meet all financial demands and responsibilities. In addition to actual assets, high liquidity also means having financial capital - known simply as net worth or wealth. Financial capital can be determined by measuring the difference between liabilities and assets, and it establishes the cushion you comfortably have to absorb losses. Examples of assets that improve liquidity include:
- Well-Established Markets
- Money Markets
- Stocks and Bonds
What is an Illiquid Asset
What are illiquid assets? They’re any asset that can’t be quickly or easily sold or converted into cash without assuming a significant loss in value. Alternative investments such as venture capital, private equity and real estate are illiquid in that they can be difficult to sell. This difficulty can be due to a lack of buyers who are willing to purchase, or because of the expense involved in the sale.
It’s important to keep in mind that just because an asset is illiquid doesn't necessarily mean it’s not of value. In fact, the opposite is often true. Illiquid assets can be very high in value. They’re just more challenging to sell and get their value out of them - especially if you need cash quickly.
Example of Illiquid Asset
Illiquid asset examples can be found in any balanced portfolio, and they’re not inherently bad on their own. That said, you don’t want to have your entire investment strategy to be solely made up of illiquid assets. Examples of illiquid assets are:
- Ownership interest in private companies
- Hedge funds
- Some alternative investments
- Penny stocks
- Collectibles (art, cars, antiques)
Pros & Cons of Liquidity
Having a diversified portfolio means finding that sweet spot where you’re comfortable with how your investments and your risk align. You should definitely have some liquid assets in your combined strategy. But, like most things in investing, there are pros and cons to liquid assets.
- Flexibility - Easy to move in and out of liquid assets.
- Accessibility - Regardless of individual worth, liquid assets are accessible to almost all investors.
- Security - It can be comforting to know you have easy access to cash if you ever need it.
- Vulnerability - In volatile times and periods of market downturns, liquid assets can be particularly vulnerable.
- Irrational Price Fluctuation - Unfortunately, fluctuations don’t always make sense - as we’ve seen throughout the COVID crisis, one headline can send markets into a tailspin.
- May Not Meet Long-Term Objectives - Liquidity may not be able to keep up with inflation, another reason it’s so important to diversify.
Pros & Cons of Illiquidity
As you might imagine, illiquidity has both benefits and some drawbacks as well.
- Good for Diversification - Having all your investment eggs in one basket is never a good idea - it’s important to maintain a structured balance between liquid and illiquid assets.
- Less Volatility/Higher Returns - Typically, illiquid assets are more likely to hold their value and remain stable over a longer time period. Investors also often see a greater return on their illiquid investments.
- Can Be Useful in Down Markets - Illiquid investments might be able to help minimize your portfolio losses in a down market.
- Higher Risk - May be more well-suited for investors with a higher risk tolerance (meaning, those who are willing to risk a lot in hopes of higher returns).
- Longer Lock-Ups - Lock-up is the time period in which you will not be able to sell shares or redeem your investment.
- Longer Time on Return - It’s not uncommon for an illiquid investment to be a time commitment of five to ten years, or longer.
What Assets Makes Sense For You
Financial liquidity means being able to convert assets into cash and that your investments will likely maintain their market value can alleviate stress for investors. When liquid money is not tied up in long-term commitments, you may have more flexibility to also make some long-term, less liquid investments, too.
At the end of the day, both liquid and illiquid assets are key to having a balanced and diversified portfolio. Just how much of each you should maintain greatly depends on your individual risk tolerance levels and comfort zones.