Liquidity explained

The term liquidity is usually used in reference to investment products, with different products being labelled as “liquid” or “illiquid” assets.

Reducing it to its simplest terms, liquidity simply refers to how easily you can access your money when it is tied up in a particular asset.

Examples of liquid assets

Liquid assets are those assets which can be quickly sold or exchanged for cash without drastically impacting on its value.

An example of liquid assets are stocks and shares. This is because the stock market allows investors easy and immediate access to buying and selling stocks. This means you can access the money you have tied up in a stock very quickly, and you are relatively certain to receive the cash equivalent of its value.

Cash is seen as the most liquid asset available. This is because the cash you have sitting in your bank account or in your savings account can be withdrawn and used to buy and sell goods immediately, and without its value diminishing.

Examples of illiquid assets

An illiquid asset is an asset which is more difficult to convert into cash, and whose value is much less stable.

Real estate is often used as an example of an illiquid asset. If you need to access cash in a hurry it can be difficult to free it up from a piece of real estate. It can take a long time to sell, and the current state of the market will drastically affect its value, and the amount of money which you will receive for it.

Investments in private companies are also viewed as illiquid assets, as investors are usually not able to trade or cash in their shares until the company floats on the stock market.

What affects liquidity?

A financial instrument is all the more liquid the lower the transaction costs, the loss of capital that the conversion may entail and the time required for the conversion itself. There are several factors that can affect the liquidity of a financial instrument:

  • the negotiability of a financial instrument, in turn influenced by its transferability and therefore by its circulation on the secondary market and by the fact that the instrument is listed
  • the residual life of the financial instrument (bonds are more liquid the closer the maturity is)
  • the credibility of the issuer
  • the breadth, thickness and elasticity of the market in which the instrument is treated.

Why it’s important to understand liquidity before you invest

Before you make any investment you need to be aware of the liquidity of the asset so that you can plan your finances appropriately.

If you may need immediate access to the money you have invested, then you may want to consider investing in more liquid assets such as stocks or mutual funds. Conversely, if you want to find an asset in which you can leave your capital for a long time, and hopefully increase in value, then real estate or funds that track the performance of underlying indices may be a good alternative.

Your capital is at risk, and past performance may not be a reliable indicator of future results. Oval Money is not permitted to provide financial advice, and if you have any questions please consult an expert.

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