Investment Liquidity Explained

by Neal Frankle, CFP ®

Investment liquidity refers to how quickly you can sell a particular investment and receive cash for it in exchange. If it doesn’t take long to accomplish the trade, your investment is said to be very liquid. If it typically takes a very long time to convert an investment into cash, it is considered illiquid.

Which investments are liquid?

In reality, every investment is liquid and you’ll see why in a minute. For now, let’s get back to our discussion.

Cash is extremely liquid. In fact, cash defines liquidity. Also, stocks are considered pretty liquid.

With stocks, all you generally have to do is place a market order to sell your shares and within 3 days, your trade will “settle”. After settlement, you’ll receive your cash.

Shares are especially liquid if they are heavily traded. In other words, if millions of shares are traded every day it won’t be hard for you to sell your shares at the prevailing market price whenever you like.

This is not the case with “thinly traded” stocks. A thinly traded stock is one that isn’t traded very much. If very few orders come in to buy or sell this stock every day, you may find it very difficult to sell your shares when you want to at the price you want to receive.

As a result, thinly traded shares may not be as liquid as you think. And it gets worse. When very few shares are traded, there is usually a huge difference between the buy and sell price – known as the “spread”. The larger the “spread”, the greater the slippage (difference between the market price of the stock and what you will ultimately get when you sell) and that means thinly traded stocks cost more to trade than heavily traded shares. Illiquidity is directly responsible for these additional costs.

If you use a good online broker like Scottrade, you can check on the liquidity before you decide to make an investment. That is a very smart move.

Bonds are considered liquid although somewhat less liquid than stocks. While you can usually sell your stock shares instantly, it may take several hours (or days) to unload your bonds. Why?

The vast majority of bonds are traded by professionals between themselves and they prefer to deal in very large trades. We are talking about multi-million dollar transactions. If you want to sell your $25,000 or even $100,000 bond, it may take a while to find a buyer. So bonds are liquid but not quite as liquid as other securities.

Real estate is not considered very liquid. It can take months, years or decades to sell a piece of real estate at a price you think is fair. The same is true with regards to selling a small business. When it comes to real estate and/or small businesses, there are a smaller number of qualified people who have the resources and desire to buy compared to stocks. Let’s look at an example.

Millions of people have the capacity and desire to own (at least a few) Apple shares. But how many people have the capacity and know-how to buy and manage an apple orchard? Far fewer. As the number of buyers and/or sellers gets smaller, the investment becomes less and less liquid.

Why Everything I Just Said Is Wrong

In reality, every investment is liquid. It just depends on the price you are willing to sell for. Let’s say you are fortunate enough to own 10 city blocks in Manhattan. That property might have a market value of several billion dollars.

If you are in a pinch and need to sell that property fast, you can do so. All you have to do is drop your price by 80% and I guarantee you’ll have your money within a few hours. That’s an example of taking an illiquid investment and making it very liquid. It also illustrates one of the most important lessons every investor must understand:

No matter how great an investment is, if it’s not liquid, it increases your risk. So the more money you allocate to illiquid investments, the more time you must be willing (and able) to wait to convert those investments into cash.

You never know what the future holds and as a result you have to be ready for anything. If all your investments are illiquid – you are asking for trouble. Very big trouble.

This is not to say that buying real estate or owning your own business (the two least liquid investment there are) are bad ideas. I think they are wonderful ideas. But to invest in real estate or a business without making contingencies for their lack of liquidity is super dangerous. Please don’t ignore this risk.

How liquid is your portfolio? Have you ever paid for the price for having illiquid investments?

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{ 2 comments… read them below or add one }

Neal Frankle December 27, 2012 at 9:39 AM

Agreed Krant Cents. Liquidity can make a great investment a nightmare.

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krantcents December 27, 2012 at 9:01 AM

With interest rates and real estate values so low, many people are interested in investing. The biggest shortcoming of real estate is liquidity. If it is a good investment, you must consider liquidity.

Reply

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