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Understanding liquidity in Investment and Trading
When you speak of liquidity, it can refer to many things. So here are a few contexts in which liquidity is discussed.
Market: When speaking of market liquidity, it refers to how well can you buy and sell assets in the market. For example, if you’re talking about stock market liquidity, then what you’re essentially discussing about is how easy it is to buy and sell stocks in the stock market. If you’re talking about the antiques market, then you’re talking about how easy it is to buy and sell antique stuffs. This is kinda like what we’re talking about, but this isn’t really what we’re discussing today.
Accounting: If you’re talking about liquidity in the accounting sense, you’re talking about how able a company is in paying off its financial obligations. Investors sometimes look into this to get a sense of how well is a company currently doing, but we’re not talking about this now.
Asset: When you’re talking about asset liquidity, then what you’re referring to is how easy can you buy or sell a particular type of asset, e.g., how easy can you buy and sell stocks, bonds, real estate, arts, and so on. This is what we’re going to discuss today.
What is liquidity?
Let’s start with the basics, shall we? Liquidity is just a fancy way of describing how easily you can turn your assets into cash. Think of it like a Slurpee. Trying to slurp Slurpees that have partially melted (more liquid) is way easier than sucking on ice-solid ones right?
In the same way, if your assets are liquid, then you can easily slurp up that sweet, sweet cash without any trouble. But if your assets are illiquid, well, let’s just say you’ll be sucking on that straw for a while.
Now, let’s talk about liquid assets. These are assets that can be easily converted into cash without losing their value. Some examples of liquid assets include cold hard cash (or digital money, if you’re one of those fancy tech types), stocks, and bonds. Basically, anything that can be easily traded for cash falls under the category of liquid assets.
Moving on to liquid investments. These are investments that can be easily bought and sold without affecting the market price. For example, if you’re investing in a popular stock like Apple (NASDAQ: AAPL), then it’s pretty easy to buy and sell your shares without causing any major market changes. But if you’re investing in a small, lesser-known company, then buying or selling a large number of shares could potentially affect the stock’s value.
Why is it important?
Let’s put it like this. You have an asset that is so valuable, the price is super high, but the liquidity is (sadly) super low. You then run out of cash for the month and you thought, hey, why not sell this asset while the price is super high, right?
The problem with illiquid assets is that it’s hard to get a buyer. Even if you get one, they would usually be willing to buy at a price lesser than the market value. Why? Because they will be bearing the burden of having to look for willing buyers next.
So, if you have an illiquid asset, you might want to consider your investment cost, as well as the actual price at which you can sell the asset.
2. How quickly can you sell?
When I started investing, my mistake was that I didn’t care much for liquidity. At that point, my dumb self thought, “as long as the price goes up then I’m in good hands”. Little did I know how the market works.
At that point, the price of the stock peaked, I was so eager to sell it and get myself some of that sweet cash, so I put in a sell order (basically auctioning it on the market). I waited, and waited — and waited… No one is buying it. After centuries of waiting, the next thing you know the price fell, and there go my dreams and hopes.
That’s why liquidity is important, especially for traders*, you want to be able to sell your asset quickly and grab the cash before the window closes. Or else you’ll bask in regret while listening to Ricky Nelson’s Lonesome Town thinking of how greener the grass could have been.
*What is the difference between investors and traders? Traders/Active investors are the ones that frequently buy and sell stocks.
3. Manage your financial planning.
Assets with lesser liquidity aren’t all bad. You could generally say that in many cases, assets with higher liquidity are less likely to increase in value over a short period of time, and are more susceptible to economic events like inflation. So, many are using the less liquid assets as a hedge against inflation and these turns of economic events.
However, you have to also take into account that since illiquid assets have lesser willing buyers and willing sellers, the spread (a fancy term for difference in price) in ask and bid price is usually much higher.**
So, if you have a target to make a certain amount of money in a certain amount of time, you’ll have to take into account that sometimes you’ll have to sell your assets for less.
**Ask price: How much seller is willing to sell it for.
Bid price: How much the buyer is willing to buy it for.
Examples of Liquid and Illiquid assets
Here are a few examples of assets that are usually liquid or illiquid. Do note that these examples are not comprehensive, and some specific assets may differ from the general group.
Cash: This is the most liquid asset because it can be easily spent or transferred.
Money market instruments: These are short-term, low-risk investments that can be easily converted to cash, such as certificates of deposit (CDs), treasury bills, and commercial paper.
Marketable securities: These are investments that can be quickly bought or sold in the market, such as stocks, ETFs, bonds, and mutual funds.
Bank deposits: These include checking accounts, savings accounts, and money market accounts.
Certain types of derivatives: Derivatives like options and futures can be easily bought and sold, making them relatively liquid assets.
Real estate: This is an illiquid asset because it can take a long time to find a buyer, complete the sale, and receive the proceeds.
Private equity: These are investments in privately held companies, which are not publicly traded, making them harder to sell.
Artwork and collectibles: These assets are unique and may have a limited market, which can make them difficult to sell quickly.
Patents and trademarks: Although they have value, these assets may be hard to convert to cash quickly.
Fixed assets: Things like equipment, machinery, and buildings may be hard to sell quickly and may require significant time and effort to find a buyer.
- Liquidity refers to how easily assets can be converted into cash without losing their value.
- It is important for investors and traders to consider liquidity when managing their finances, as illiquid assets can be difficult to sell quickly and can result in losses.
- Liquid assets include cash, stocks, and bonds, while illiquid assets include real estate, arts, and other assets that are difficult to sell quickly.
- The spread in the ask and bid price can be much higher for illiquid assets, making it harder to sell them at market price.
- It is important to manage financial planning and investment strategies with liquidity in mind.
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