Liquidity, And Why It Matters
What is liquidity?
In finance, liquidity is the measure of how quickly and easily an asset can be converted into cash, without affecting its value. Liquidity is a fundamental concept that can influence investment decisions entirely.
Every type of asset has its own level of liquidity, and these levels can vary extremely drastically. Some assets can be converted back to cash within seconds, while others can take months.
Why liquidity matters
In the event of an emergency, one might have to sell (liquidate) their assets, to get cash to pay for emergency hospital bills, housing costs, etc.
In such scenarios, how quickly and easily you can sell the asset to raise cash becomes a critical factor. And that’s exactly what liquidity is about.
Cash itself is the most liquid asset, since it can readily be used to pay for things. Then you have slightly less liquid assets, like money in special savings accounts that might require longer processing times to withdraw.
A little further down, you find assets like stocks, which are still relatively liquid. But you’d need to wait for the stock market to open, and for someone to be willing to buy the shares you’re offering to sell (which is usually not difficult).
Then you have assets with even lower liquidity, like real estate. Think about how much more quickly one can sell their stocks than to their investment properties.
Understanding liquidity
An asset’s liquidity is not just about how quickly it can be sold, but also the fact that it needs to be sold at a relatively similar price to its current market value.
For instance, stocks are more liquid than real estate. But theoretically, you could offer your property for sale at a dirt-cheap price and sell it to the next person you walk past within a few minutes. But does that make it a truly liquid asset? No, because it was sold significantly below its market value.
Measuring liquidity takes into account not just the absolute quickness of selling, but also the price that the asset is sold for, and that’s something that often gets overlooked.
Implications
Conventional wisdom says that one should desire to hold a significant portion of their net worth in highly liquid assets.
Personally, I don’t disagree. The world is volatile and surprise costs be unpredictable in both timing and magnitude. Having a beefy sum of liquid assets might just be the life-jacket that one needs to stay afloat in the event of a financial emergency.
A nuance to this that I live by, is that high liquidity is not everything. For instance, most would consider stocks as a relatively liquid asset. After all, they can be sold readily at the market price on any given day.
However, the current market price could be lower than the price you bought the investment for – perhaps stocks are going through a bear cycle right now and stocks are down.
Even though, on paper, the stocks have high liquidity, in reality, it would be a shame to have to sell those stocks at a loss prematurely. Especially if one has confidence in their long term recovery and performance.
That’s why I prefer not to count stocks as part of my “liquid assets stash”. Because my intention is to hold them for the long term and have no intention to liquidate them prematurely unless absolutely necessary.
Personally, my stash of “liquid assets” would include mainly cash itself and cash equivalents.