What is Liquidity and Which Investment has the Least Liquidity?

Investors prefer to choose the most liquid assets to make their portfolio generate low-risk returns. The liquidity of an asset is determined by how easily it can be converted into cash at market price.

Quick Insights

• •  Assets having the ability to be quickly convertible into cash without affecting the current market price are considered liquid assets.

• •  Liquidity of an asset determines the overall risk and also the potential returns of the portfolio the investor holds.

• •  Investors choose between liquid or illiquid assets based on their financial objectives and risk tolerance.

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What is liquidity?

Liquidity is the degree of availability of an asset or security to purchase or sell at its current market price of any quantity. Put simply, the easiest and quickly an asset can be bought and sold, the more liquidity it is said to have.

When an asset is liquid, it refers to having been most actively traded by a large number of buyers and sellers. Examples of liquid investments include,

• • Government bonds

• • Treasury bills

• • Blue chip stocks

• • Money market instruments etc.
    
    

    There are a few drawbacks to investing in illiquid assets. They are,

• • Since illiquid assets can’t be quickly or easily converted into cash, investors find it difficult to access their funds in urgent need.

• • Illiquid assets require long-term commitment and investors have to bear huge penalties on pre-closing.

• • Illiquid investments are not as transparent as liquid assets. Assessing the risk and calculating the real worth of the asset is quite challenging.

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Examples of liquid investments

Investors often prefer liquid investments to ensure they can access funds quickly in times of need. Below are some of the most common liquid investment types:

• Savings accounts: Easily accessible cash reserves for emergency needs.
• Mutual funds: Although they involve risks, mutual funds offer relatively high liquidity.
• Stock market investments: Stocks of major corporations are highly liquid, given active daily trading.
• Exchange-Traded Funds (ETFs): ETFs allow easy entry and exit due to their listing on stock exchanges.

These examples highlight how liquid investments enable immediate fund accessibility without a significant loss in value.

Factors affecting liquidity

The liquidity of a security is affected by numerous factors in the market. They are,

Demand and supply

The more buyers and sellers participate in the trade of security, the more it is quick and easy to buy or sell.

Economic conditions

Financial crises or economic instability may cause panic among investors, thereby making them more cautious about buying assets.

Government regulatory changes

Some policies and regulatory activities by the government restrict certain trading activities of the assets to buy or sell.

Asset Variations

Different types of assets have different levels of liquidity. For example, government bonds always have more liquidity than the corporate bonds.

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Which investment offers the least liquidity?

Assets that are low in liquidity are high-risk for both short-term as well as long-term investments. However, assets being non-liquid or illiquid can offer greater returns over time. Let us discuss the liquidity of each investment below:

Small-cap stocks

Stocks usually have high liquidity but small-cap stocks have less liquidity due to the availability of fewer outstanding shares in the market. They also have a smaller investor base compared with large-cap stocks, resulting in lower daily trading volumes.

Real estate

Liquidity in real estate depends on the location and the type of the property. For example, residential properties in metro cities and prime locations can be easily bought or sold at any time. Commercial real estate assets involving huge investments and regulatory approvals affect liquidity most of the time.

Arts and collectibles

Risks involved in arts and collectibles investments such as availability of limited potential buyers, trends, research, artist’s reputation, demand, storage and insurance, volatility, etc., make arts and collectibles highly illiquid. They are also less reliable compared with stocks and bonds.

Precious metals

Precious metals such as gold and silver are usually world-wide safe-haven assets for everyone. Though physical gold and silver have low liquidity, ETFs and securities of gold and silver are highly preferred liquid assets for all types of investors.

Certificates of Deposits – CDs & Savings bonds

Since the tenure of the deposits is longer and early withdrawals attract more penalties, CDs and savings bonds are considered illiquid investment assets.

401(k) Retirement Plans

A 401(k) is a popular retirement savings plan that allows employees to contribute a portion of their salary pre-tax. While it offers long-term growth benefits and often includes employer matching contributions, it is considered an illiquid asset. This is because withdrawing funds before the age of 59½ usually incurs early withdrawal penalties and tax implications, restricting liquidity for short-term needs. However, 401(k) loans or hardship withdrawals may offer limited access in emergencies.

Cryptocurrencies

Cryptocurrency investments have been attracting modern investors only in the recent past. Popular cryptocurrencies such as Bitcoin, Ethereum, etc are highly liquid yet certain exotic and the others are relatively very illiquid.

Commodities

Most of the time, investors buy commodity futures or physical commodities for diversification. Though futures contracts can be liquid, physical commodities are too difficult to sell. It is also a complicated process to cash-in cryptocurrencies.

Ownership in private companies

Direct ownership gives sure potential returns yet it is too difficult to find a buyer for the owned shares. Moreover, they are not traded in public, and hence private equity ownership is an illiquid investment.

Hedge funds

Liquidity is the primary concern in hedge fund investments. Many funds have lock-in periods that restrict investors to withdraw money during the tenure.

Common misconceptions about liquidity

• Liquidity equals profitability: Many investors believe highly liquid assets always generate high returns, which is not true. Liquidity is about accessibility, not profitability.
• Illiquid assets are inherently risky: While illiquid assets pose challenges in short-term accessibility, they can offer substantial long-term returns.
• Cash is always the most liquid asset: While cash is liquid, certain marketable securities like Treasury bills might offer better stability and returns without compromising liquidity

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Advantages of illiquid investments

Investors have both liquid and illiquid assets to balance their portfolios. Despite its risk, illiquid investments are preferred for a few reasons.

Potential returns

The requirement of long tenure in illiquid investments allows value appreciation. Most of the time, returns derived from illiquid investments are much better than those of liquid investments.

Stability

Illiquid assets are not volatile like liquid assets. They are reliable and make steady growth even amid adverse market conditions. Hence, illiquid assets provide a hedge against market volatility and are best suited as a diversification option.

Tax benefits

Investors have more tax benefits in illiquid assets due to the nature of holding long tenure. Private equity and real estate offer tax advantages and preferential tax benefits on capital gains.

Retirement accounts like 401(k) plans provide tax-deferred growth and, in some cases, employer matching, which boosts the overall return on investment. This makes them an attractive option despite their illiquidity.

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Conclusion

Investments that have the least liquidity are direct ownership of private companies, real estate, art and collectibles, etc. Illiquidity doesn’t mean the investments are not good, yet they provide less market risk and higher returns.

Frequently asked questions

1. Which are illiquid assets?

Assets that cannot be quickly sold without a loss in market value are called illiquid assets.

2. What is the liquidity ratio?

The liquidity ratio is a measurement to calculate the debtor’s ability to pay off the debt obligations without raising capital.

3. What is liquidity in stocks?

Liquidity in stocks involves how quickly and easily a huge quantity of stocks can be bought or sold without affecting the market price.

4. What does low liquidity mean in stocks?

Low liquidity in stock means, the investor is not able to cash in the equity stock in the desired quantity at its current market price.

5. What is exit liquidity?

Exit liquidity refers to the ease of the traders’ exiting positions and cashing out their cryptocurrency assets.

6. Why is an investment with more liquidity ideal for someone who knows they will need cash soon?

Investments with more liquidity, such as money market accounts or short-term funds, allow easy access to cash, making them perfect for someone with near-term financial needs.