It’s undoubtedly never been a better time to start investing. But perhaps one of the most overlooked and underrated concepts is investment liquidity. It’s something that’s so crucial for every single investor, it’s frankly astonishing more investors don’t consider this actively as part of their investment strategy.
With the abundance of investments brokerages and apps popping up constantly in 2022, the average person now has the ability to invest in various assets and stocks.
But what exactly are the differences between the terms: investment, asset, and stock?
Generally, an investment is defined as placing your money into something, with the expectation of it, hopefully, increasing in value and making you a return on your money in the future.
An asset is similar to an investment but is a term that encompasses “all items of property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies”, according to Google.
Finally, a stock can be considered a specific type of investment, typically in a company.
An investor places their money in a company and, in return, becomes a “shareholder”, that owns a, usually, tiny portion of a company’s overall value.
The investor then hopes for their investment and stock in the company to increase in value, making them profit in the future if they were to then sell that stock.
This is from the perspective of going “long” in a stock instead of shorting a stock, which is outside the scope of this particular article.
Now that the definition of all three terms has been established, we need to determine what “liquidity” means.
Liquidity, generally, refers to how readily one of the aforementioned things (investments, assets or stocks) can be sold and turned into cash.
In this article, we’ll be covering everything related to investment liquidity, so you can gage a broader understanding of what it means, as well as why liquidity management is an important concept to know when evaluating your investment portfolio.
What Is Investment Liquidity?
Investment liquidity simply refers to how easily an investment or asset can be turned into cash.
Please note that investment liquidity should not be confused with the process of ‘liquidation’, which is “the process of bringing a business to an end and distributing its assets to claimants”.
Therefore, a liquid asset is one that is easily and quickly able to be turned into cash, because the asset can be sold with little impact on its value.
What Determines An Investment’s Liquidity?
There are several factors that determine whether an investment/asset is liquid, including:
1. How Established The Market Is
A more established market tends to have a better reputation than a more unknown one.
Consequently, investors within an established market are more likely to trust trades and investments within it, attracting a larger potential pool of buyers to sell an investment or asset to.
On the flip side, a less established market tends to draw less investors, which results in less potential buyers to purchase your investment/asset.
This time delay between when you want to sell your investment/asset and when a buyer purchases it will decrease its liquidity.
An example of an established market index is the FTSE 100 or the S&P500.
With thousands of trades occurring simultaneously throughout each day, it’s likely that an investor would be able to sell their stock quickly and with ease, turning their asset (stock) into cash.
Incidentally, generally speaking, the more ‘established’ a market is, the more ‘efficient’ that market likely is in the context of the Efficient Market Hypothesis (EMH).
2. How Easy And Fast The Transfer Of Ownership Is
The faster and smoother a transfer of either an investment or asset ownership is between owners, the more liquid they are.
Buyers of an investor’s asset want to reduce their fear of investing or anxiety of a trade by knowing that they’d receive the ownership of an asset or investment as soon as they buy it.
An example of investments that are accommodated with easy and fast transfer of ownership is, again, a stock (although there are, of course, exceptions as the stock is dependent on the company).
With the many popular brokerages that exist nowadays, the transfer of ownership of stocks is almost seamless as the broker conducts the transfer automatically and behind the scenes of an investor’s transaction (for a fee, of course).
3. Daily Transaction Volume
Similar to the first point relating to how established a market is, stocks and assets that attract a larger number of market traders that can maintain a tighter two-sided market would be perceived to be more illiquid.
Illiquid stocks have wider bid-ask spreads and less market depth.
If you’re wondering what bid-ask spreads are, we go over it in our sister article on How to Read Stock Numbers.
It’s important to specify that a small, less known market does not always mean there are less traders in it.
Sometimes, a small market can still attract a large number of buyers, making the stock(s) or asset(s) being traded in it more liquid.
What Investments Are Most Liquid?
So now we’ve established what factors determine how liquid an investment or asset is, here are three of the current most common liquid investments:
Although it may sound rather obvious, many people forget that cash in and of itself is an asset.
Clearly, cash, being the definition of liquidity, is the most liquidible asset class to exist.
Some cash investments and assets can include current/checking and regular savings accounts offered by banks, as well as term deposits.
The downside of holding cash, however, is that it’s the asset class that gives the lowest returns on an investor’s money.
This is simply because you’re not staking your money in an investment or asset that has the potential to either increase or decrease in value.
Put differently, it’s because you’re susceptible to the adverse effects of the Time Value of Money.
Despite cash’s zero growth capacity, it still has the most protection from market risk, but can be susceptible to inflationary pressure overtime, which can slowly erode its initial value.
2. Fixed Interest Assets
A fixed interest asset means that an investor agrees a fixed interest to pay an investee over a certain period in exchange for an immediate cash deposit.
Fixed interest assets, such as bonds (securities that are sold by companies or governments that need additional capital) can be bought and sold relatively quickly, because they’re typically low risk and guarantee a fixed amount of income over time.
Bonds are generally regarded as a defensive type of investment because they’re relatively safe as a result of less volatility in their values as opposed to high volatility asset classes like cryptocurrencies.
Bonds are also easily sellable, but an investor may have to deal with losses from transaction fees.
Shares, as briefly explained above, are a medium to long-term investment.
In addition to the actual value of a share price changing (either appreciating or depreciating), companies reward investors (known as “shareholders”) for risking their money in them by paying out dividends (payments) when they earn a profit.
However, the value of each share differs and may drop below the price an investor initially purchases it for.
The value of a share can fluctuate daily due to active market trading.
The type of company stock that an investor put their money into generally decides it’s liquidity.
A well-known company with large market capitalization is likely to have many active traders daily, meaning an investor’s investment would be highly liquidible.
In contrast, a smaller, lesser-known company is likely to have less investors who would be willing to purchase an investor’s stock if they were to try and sell it.
Consequently, this would decrease the liquidity of a stock.
What Are Considered Illiquid Assets (Poor Investment Liquidity)?
On the opposite end of the spectrum are illiquid assets. Here are a few examples of the most illiquid assets below:
1. Real Estate & Property
Although known to generally to be decent investments, real estate and properties are one of the most illiquid assets a person can own.
Why is this? Despite a property likely holding significant value, converting that value into cash through a sale takes time, effort, and money.
To artificially increase a property’s liquidity, the investor could significantly cut its price to attract buyers more quickly.
However, the result of this would mean accepting a loss on the property’s value and potentially losing a significant amount of money on the investor’s initial investment.
An investor would typically only do this if they’re in desperate need of cash.
It’s for this reason, therefore, that investors are only advised to tie their money up in a property if they’re looking for a long-term investment.
2. Mutual Funds
Mutual funds are another common example of an illiquid asset.
A mutual fund is an investment whereby an investor places their money in a large pool of sourced money, known as a ‘fund’, that is run by several ‘fund managers’ who use their investors’ to invest in different stocks and asset classes (the type of stock(s)/asset(s) depends on the type of mutual fund).
The reason for their illiquidity is that many of them have rules that restrict the owner’s ability to sell their shares in it immediately.
While it’s still possible, it’ll often be accompanied with a steep penalty.
However, since mutual funds, traders have created exchange-traded funds (ETF) as a liquid counterpart to the typically illiquid mutual funds.
Vanguard, another of the largest brokerages in the U.K., has a great page explaining what an ETF is here.
What Is An Investment Liquidity Fund? And Is It Good To Invest In One?
A broader term that encompasses ETFs mentioned above, liquid funds are used by investors to essentially “park” their money for a short period of time that they might need a few weeks or months later.
As opposed to a mutual fund, an investor can withdraw their money from the fund at any point in time without a costly exit fee.
This means an investor can earn accrual on their liquid fund investments on a day-by-day basis.
Investors would be advised to invest in liquid funds if they meet the following criteria:
- When they have a lump sum they’re planning to use for long-term investing but would prefer to invest their sum periodically through a systematic transfer plan (STP) into another asset class over time (instead of all at once).
- If they want to create an income stream by investing their lump sum savings into a liquid fund to receive a monthly amount.
Why Managing Investment Liquidity Risk Is Important
Generally, investors tend to gravitate toward more liquid investments because they are risk-averse and want to make sure they can quickly turn that money into cash in case of an emergency.
However, a portfolio of investments that span the liquidity spectrum is advised to create a broader opportunity for both investments that would accrue value of a long period of time to help achieve long-term goals and short-term investments where cash can be retrieved quickly when needed.
Here are some of the benefits of combining investments and assets of many liquidity levels:
1. The “Illiquidity Premium”
In return for more illiquid assets, investors typically expect a higher rate of return than less liquid ones.
This is known as an “illiquidity premium”, that investors should capitalise on when negotiating the price on their investments.
2. Risk Adjusted Returns
Having both liquid and illiquid assets may improve risk-adjusted returns.
This means that an investor’s returns are smoothed out across assets varying in risk levels.
So, if one highly volatile liquid asset were to depreciate suddenly, your long-term illiquid investments would help balance out your portfolio to help minimise an investor’s loss.
3. Illiquid Assets Tend To Bring Higher Returns Over A Longer Time Frame Than Liquid Ones
Relating similarly to the illiquidity premium, having both the ability to sell and retrieve liquid investments in combination with long-term, higher returning illiquid assets help to create a balanced portfolio.
Naturally, this very much also depends on your individual risk preferences and tolerance.
To conclude, investment liquidity can be summarised as the ability for an investment or asset to be easily and quickly converted back into cash.
The longer it takes for this to happen, the more illiquid an investment or asset would be considered to be.
Cash, stocks, and fixed interest assets such as bonds are generally considered to be liquid assets, whilst property and mutual funds are some examples of illiquid assets.
It’s important for an investor to manage their liquidity investment ratio mainly to help balance their portfolio to mitigate large fluctuations in value and to offset potential sudden changes in the price of all assets in it.