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
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- Assets having the ability to be quickly convertible into cash without affecting the current market price are considered liquid assets.
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- Liquidity of an asset determines the overall risk and also the potential returns of the portfolio the investor holds.
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- Investors choose between liquid or illiquid assets based on their financial objectives and risk tolerance.
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,
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- Government bonds
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- Treasury bills
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- Blue chip stocks
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- Money market instruments etc.There are a few drawbacks to investing in illiquid assets. They are,
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- Since illiquid assets can’t be quickly or easily converted into cash, investors find it difficult to access their funds in urgent need.
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- Illiquid assets require long-term commitment and investors have to bear huge penalties on pre-closing.
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- Illiquid investments are not as transparent as liquid assets. Assessing the risk and calculating the real worth of the asset is quite challenging.
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.
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.
Venture Capital and Private Equity
Investments in venture capital and private equity are highly illiquid because they involve high capital commitments with a long investment horizon. Exiting such investments may take years and often requires finding a buyer for the shares or waiting for an acquisition or IPO.
Farmland and Timberland
Investing in farmland and timberland is often illiquid due to the large capital involved and the lengthy time it takes to sell these assets. However, they may offer long-term returns and act as a hedge against inflation.
| Investment Type | Liquidity | Risk | Potential Return | Examples |
| Cash | Very High | Very Low | Very Low | Physical currency, checking accounts |
| Government Bonds | High | Low | Low to Moderate | Treasury Bonds, T-bills |
| Blue Chip Stocks | High | Moderate | Moderate to High | Apple, Microsoft, Amazon |
| Mutual Funds | High | Moderate | Moderate | Stock funds, bond funds |
| Exchange-Traded Funds (ETFs) | High | Moderate | Moderate to High | S&P 500 ETFs, sector ETFs |
| Corporate Bonds | Moderate | Moderate | Moderate | Investment-grade corporate bonds |
| Real Estate | Low | High | High | Residential, commercial properties |
| Small-Cap Stocks | Low | High | High | Startup or emerging market stocks |
| Private Equity | Very Low | Very High | Very High | Venture capital, private firms |
| Arts and Collectibles | Very Low | Very High | High | Paintings, rare antiques |
| Commodities (Physical) | Low | High | High | Gold, Silver, Oil |
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
- All Assets Are Easily Liquidated: Many investors assume all assets can be easily liquidated without loss of value. However, some assets, like real estate and collectibles, may be difficult to sell quickly at desired prices, especially in times of market instability.
- High Liquidity Means Higher Returns: While liquid assets are easy to sell, they don’t necessarily provide higher returns. Investors often assume liquidity equates to better performance, but illiquid investments can often generate better long-term returns.
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.
Retirement accounts like 401(k) plans
It 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.
Diversification Opportunities
Illiquid investments offer a means of diversifying a portfolio beyond traditional liquid assets, helping to reduce overall risk and increase potential returns. This diversification can help in minimizing the impact of market fluctuations.
Risks of illiquid investments
- Hard to Sell Quickly
The primary risk with illiquid investments is that they cannot be sold quickly, making it difficult to access your money in times of need. - Price Volatility During Sale
Illiquid assets often experience greater price volatility when it comes time to sell, as the lack of a ready buyer can force prices to fluctuate significantly. - Lack of Market Pricing Transparency
Illiquid investments are often not regularly traded, which means their market prices can be opaque, leading to difficulty in determining their true value.
How to manage liquidity risk in your portfolio?
- Diversify Across Asset Classes
Balancing liquid and illiquid assets in your portfolio helps mitigate liquidity risks. Diversification spreads the risk and ensures that you are not overly reliant on any one asset type. - Keep an Emergency Cash Reserve
Maintaining an emergency fund in liquid assets ensures you have immediate access to cash if necessary, without needing to sell illiquid assets. - Understand Exit Strategies Before Investing
Having a clear exit strategy helps manage liquidity risk. This involves knowing when and how you can sell assets, particularly illiquid ones, should you need to access funds quickly.
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.
Pro Tip
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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.
