Investments: Episode 26
Liquidity is incredibly important to a successful investment strategy yet few people pay much mind to the fact that it may be hard to sell their assets in the future. Not all assets can be converted to cash quickly and with ease. Liquidity risk is the chance that you will either need time to convert an asset to cash or the conversion of an asset to cash will materially impact its value negatively.
A profit is only realized when you sell an asset for more than you paid for it. Until then you only have an unrealized "paper" gain. We use cash in our society to buy goods and services. Even gold, which some view as a storage of wealth, is priced in dollars and must be converted to cash to be used for exchange for the things you want to buy.
There a few factors that impact liquidity:
- Size of the Market: The more potential buyers in the market for your asset the more likely it is that you will be able to sell it at a fair market price within a reasonable time. If the market is small it may take awhile and you may be at the mercy of the buyer.
- Activity of the Market: If the market is small it may still be active. Think of all the instances where there are specialists trading frequently.
- Ease of Valuing the Asset: How much is your house worth? How much is a share of Apple stock worth? How about the paint store in the center of town, what would you pay for that? Some assets are easier to price than others.
- Ease of Transferring Ownership: It's not always easy to transfer ownership. When selling real estate you need to get the government involved to transfer the deed and make sure the title is clean. Selling stock is easy, just click sell or call your investment manager.
Types of assets and their liquidity profiles:
- Cash and near cash assets like money market funds are very liquid.
- Open ended mutual funds are very liquid but you have to wait for the closing price. If the fund prices lower than you hoped you'll experience a liquidity risk bummer.
- Stocks and bonds of large volume and active trading are very liquid. Click sell at market price and you've liquidated your position. But, T+3 means you need to wait three days to get your hands on the cash.
- Small cap and emerging market stocks are often less liquid than their larger more developed counterparts. Selling your shares may actually push the stock price down.
- Private companies, real estate and physical assets can take a while to sell. And you might not get what you emotionally feel the asset is worth.