Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Liquidity

What it is:

Liquidity is the ability to sell an investment at or near its value.

How it works (Example):

Let’s say you take an old painting from the attic to the local filming of Antiques Roadshow. The expert says your painting is worth $50,000. Surprise!

That’s great news, except that it could take months to find a buyer, and the buyer may only want to pay $35,000 or $40,000. Your painting, while valuable, isn’t very liquid. That is, you can’t convert it to $50,000 very quickly or easily. Houses aren’t very liquid, either. They too can take months to sell, and buyers often don’t pay the sticker price.

Why it Matters:

Liquidity is a factor of supply and demand for a security. But it is also affected by the size of the original issue and the time since the original issue -- the smaller the number of securities out there or the longer the securities have been out there, the less liquid they tend to be.

Most people consider the size of the bid/ask spread as indicative of a security's liquidity -- the larger the spread, the less liquid (and thus the riskier) the security is. For example, let’s assume you are watching Company XYZ stock. If the bid price is $50 and the ask price is $51.50, then the bid-ask spread is $1.50. This spread may be high or low depending on what the spread typically is for Company XYZ stock. An increasing spread denotes increasing liquidity risk, and vice versa. In the worst-case scenario, liquidity risk makes it possible that the investor could take a loss if he or she has to sell the investment quickly.

All investments have liquidity risk. This is important to understand, because liquidity risk can compound other problems for investors. For example, if the investor is unable to liquidate his or her position, this may keep him from meeting debt obligations (that is, the liquidity risk increases the investor's credit risk). Buy-and-hold investors face less liquidity risk because they are generally not interested in buying and selling securities quickly. This is particularly true for buy-and-hold bond investors, who are simply waiting for their bonds to mature and are not concerned with interim price movements.

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