A deep dive into investment liquidity
Let’s open the floodgates on liquidity—what it is, what it’s determined by, and its associated risks. Full steam ahead!
Liquidity refers to how quickly (and easily) an investment can be turned into cash at its market price. If it’s fast and inexpensive to convert, then it’s considered more liquid.
For example, the cash in your bank account is considered very liquid as it’s ready to spend almost instantly. In comparison, a house is a fairly illiquid investment. To turn it into cash, you’d have to sell it, or get your bank to loan you money against it. Both those options will take time and cost money.
Think of liquidity as a spectrum. Every type of investment you can make will fall somewhere on the scale.
What determines liquidity?
So, we know that the liquidity of an investment depends on how quickly it can be converted into cash, but what are the factors that impact how quickly this happens? Ultimately, it comes down to how easily a buyer and seller can come together and agree on a price for the trade.
The more people there are wanting to buy and sell an investment at the same price, the faster and easier it is to make the trade. As a result, bigger markets can usually be considered more liquid than smaller ones. For example, the New York Stock Exchange (NYSE) is significantly larger than the New Zealand Stock Exchange (NZX), with over 9 million trades happening daily. Wowza! So even though publicly-listed shares (shares that are available through an exchange) are considered quite a liquid investment, you might find that some of your US shares sell slightly faster than your NZ shares.
Even within a market, investments can have varying levels of liquidity. For example, large, well-known companies listed on the NZX tend to have more people wanting to buy and sell their shares than smaller, lesser-known companies listed on the NZX. As a result, the bigger companies are usually more liquid. So, even though the companies technically have access to the same market (the NZX), the actual number of investors who want to invest in them can be very different. This helps explain why some orders take longer to be filled, even though they’re on the same exchange.
Who can access the investment?
The more accessible an investment is, the more liquid it’s likely to be. Listed investments (such as shares in listed companies, or units in ETFs) are more liquid than unlisted investments (investments that aren’t listed on an exchange—like an unlisted company or fund) because they can be easily bought and sold through an exchange. Unlisted investments are sometimes only accessible to certain types of investors (like institutional investors), or at certain times (like when a company or fund wants to raise capital). This can mean the investment is less liquid as it’s harder to find buyers and sellers.
Accessibility can also be affected by affordability. A house that costs $5 million dollars is inaccessible to a lot of people. There will generally be fewer buyers interested in it, so it might stay on the market for longer than a more affordable house. Similarly, some managed funds have minimum investment amounts, which makes them harder for investors to access.
How readily available are prices?
It’s much easier to sell an investment if the current market price is easy to find, as there’s less deliberation between the buyer and seller to agree on a price. The market price of listed companies and funds are readily accessible and updated frequently through the exchange they’re listed on. So, when you place a sell order for this type of investment, you generally have an idea of the price range it will sell at. For more info on what happens when you place an order through Sharesies, check out our behind the scenes blog.
Meanwhile, the price of illiquid investments can be very hard to find. If you own an unlisted investment, you can’t check an exchange to find out its latest market price. Some illiquid investments (like property, or shares in an unlisted company) rely on valuation experts to figure out how much they’re worth. These valuations might come at a cost, take time, and may only happen periodically (like every quarter, year, or for special circumstances). This means that these investors generally have to accept that they won’t always have access to up-to-date pricing, and that timings around buying and selling might be impacted by how current the pricing info is.
What are the risks of an illiquid investment?
Like most things to do with investing, there’s no hard and fast rule to determine the level of liquidity you should look for. Liquidity is another layer of risk, and there are some specific risks associated with illiquid investments to be aware of:
It can be hard to get your money out of the investment
The main risk of an illiquid investment is that it can be hard to sell your investment to turn it back into cash quickly. In an emergency, this can make it difficult to access your funds straight away. And if you manage to sell it, the potential costs of the process can cut into returns you might have made (or even your original investment amount).
Before you invest in an illiquid investment, you might want to consider when and how you’ll be able to sell the investment. If there’s a time restriction on when you can buy and sell, you may want to think about this impact on your investing strategy—for example, you might not have the option of dollar-cost averaging over time.
Pricing updates on your investment might be limited
As pricing information can be hard to gather or infrequent for some illiquid investments, it could be more difficult to track how your investment is doing. This might not be an issue for those with a higher risk appetite, but can be an added uncertainty for those who like to stay in the loop with their investments.
Illiquid investments might not suit your investment horizon
Some illiquid investments are designed to be held for a long time because of the time and cost associated with selling them. If you were to sell your investment before the intended time period, you could be negatively impacted by this. Even if you are investing for the long-term, there’s always the chance that you’ll lose some, or all of the money you started with.
What are the benefits of an illiquid investment?
Like other high-risk investments, illiquid investments can sometimes offer investors a chance at higher returns in the long run. In the finance world, this can be called a liquidity premium, and it’s usually built into the forecasted (predicted) returns of an investment.
All investments have a level of liquidity, and it’s an important factor to consider while planning out your portfolio. Ultimately, only you can determine the level of liquidity you should look for in an investment. And what you’re comfortable with will play into your investment strategy, risk appetite, and investment horizon.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.