What is Investment Liquidity?
Often, investors and companies will refer to their current liquidity. They’re typically talking about their available cash on-hand and the ability to quickly access funds. In accounting, investment liquidity is the ability for current assets to meet current liabilities, often by being converted to cash. It also refers to the amount of trading volume for a particular asset. As a general rule, liquidity is a good thing; however, illiquid investments aren’t inherently bad. The context for liquidity is often circumstantial.
Investors and companies alike need to be mindful of liquidity. If there’s too much capital locked up in illiquid investments, cash flow problems and even insolvency can creep into the picture. Conversely, having too much cash on-hand can subject wealth to inflation-related devaluation. It’s vital to find the middle ground, and to determine the ideal level of investment liquidity.
Liquidity is the ease by which an investor can redeem an asset for cash. Different assets have differing levels of liquidity. For example, it’s very easy to sell out of a stock position and recoup that cash in just a day or two. Meanwhile, something like an investment property has low liquidity—it takes time to transact property and turn it back into liquid cash. Every type of asset and investment has a place on the liquidity spectrum. Cash is always the object of liquidity, since it’s the universal standard for exchanging wealth.
As a side note, highly liquid assets tend to have a 1:1 exchange value. If you hold a stock worth $100 and sell that stock, you’ll walk away with $100 (barring any broker fees). Illiquid investments, like property, have more variable value because they’re largely dependent on market demand and a buyer’s willingness to pay a certain price.
Investment Liquidity Leads to Opportunity
Liquidity is important because it’s a measure of how fast a person or a company can access its wealth in cash. However, investment liquidity represents another opportunity. The idea is that a person can sell out of their position in a liquid asset to reinvest those funds in another asset with better ROI prospects. Liquidity equals agility.
For example, Julia owns 100 shares of ABC Company, valued at $10,000 altogether. She decides to sell half her position to reinvest in XYZ Company. Equities are highly liquid, allowing her to sell down to 50 shares at $5,000 and reinvest the other $5,000 in 100 shares of XYZ Company. If her investing thesis is correct, she’ll see a higher rate of return on XYZ Company over the next year. As a result, her wealth will grow faster than if she left it all in ABC Company stock.
This type of reallocation is only possible thanks to investment liquidity. The more liquid the asset, the better the opportunity to identify fast-growing investments elsewhere and capitalize on them.
Liquidity Offers a Reduction in Investment Risk
Liquidity also mobilizes investors against risk. Say, for example, Julia’s investment in XYZ Company doesn’t pan out and the share price starts to slide. Because equities are highly liquid, she can sell out of her position before losses mount. While selling locks in her loss, it also prevents even bigger losses.
Juxtapose this against an illiquid asset like real estate. If the housing market in an area suffers, a property might lose $10,000 seemingly overnight. If it takes 30 days to find a buyer and agree on a price, that property might lose another $10,000—or more! Here again, selling locks in the loss, which is greater due to the time it takes to exit the position.
Liquidity as a Measure of Stock Performance
Public companies also have a measure of liquidity in how often and in what volume their stocks trade. Also called trading volume, when it’s easy to buy and sell shares of a company, that company is liquid. When demand for a company’s stock is low, it’s considered illiquid.
For example, a hot stock like GameStop (NYSE: GME) might see upwards of two or three million shares changing hands each day. Conversely, some stocks may only see 10,000 shares trade hands in a given day. If there’s a difference in bid-ask and investors can’t close the gap as buyers and sellers, fewer shares will move and the stock will see low liquidity. Sellers won’t be able to exit their positions; buyers won’t find any available shares.
While liquidity isn’t a direct indicator of the health of a stock, it does perpetuate good (or bad) technical indicators. For example, many penny stocks see high liquidity during a pump-and-dump cycle. On the flip side, some companies may see low liquidity in the period between an ex-dividend date and the distribution date.
Finding Balance in Liquidity
Liquidity is something every investor needs to keep in the back of their mind. It doesn’t matter if you’re worth $X; if you can’t access those funds and use them intelligently, your ability to invest is significantly handicapped. There’s nothing wrong with long-term, illiquid investments—they just need to be balanced by liquid, accessible funds.
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However you choose to invest, keep liquidity in mind. Pulling out of long-term investments to cover short-term debts isn’t something any investor wants to do. Instead, modulating investment liquidity allows for smarter investments and balanced wealth in the immediate. It’s better to have access to a portion of total wealth than compromise total accumulation by cutting short an investment due to lack of cash on-hand.