In the world of investing, there is a singular, most important consideration that every investor must consider before investing their hard-earned money into any asset in particular. This consideration is called liquidity associated with any asset class.
According to The Balance, liquidity describes the ability to exchange an asset for cash quickly and efficiently. A highly liquid asset is one that can be turned immediately into cash without frictions or costs. Even without getting into it, we can already begin to appreciate why the ability to immediately turn an asset you are investing in, into cash.
Liquidity is a very important factor to consider before choosing an asset to invest in. An asset class that has no liquidity is termed an illiquid asset and in extreme cases, individuals will never be able to convert such assets into cash, thereby making that asset position worthless.
It’s obvious that cash is the most liquid asset you can have, particularly in a relatively stable currency like US Dollar or the Nigerian Naira. In comparison, an asset with lower liquidity would be something less simple to convert cash. An example would be large assets such as plants, property, and equipment. Imagine you’re a minerals company and have a digger worth $5 million, you couldn’t just sell it tomorrow if you needed that money to pay off an outstanding debt.
Liquidity in the stock market
A stock is considered liquid when its shares can be bought and sold quickly, with minimal impact on its market price. Large-cap companies traded on the major exchanges are considered to be liquid: They are traded in high volumes, and so the price per share a buyer makes (which is known as the bid) is very close to the price a seller will accept (known as the ask).
Smaller-cap companies, which are traded on smaller exchanges like the NASD exchange, are more infrequently than larger-cap companies, and usually have higher liquidity risk. That means that the price per share a buyer offers could be very different than the price a seller will accept. This is known as a greater spread. When these kinds of stocks witness a surge in demand, they can also experience a lot of volatility.
Illiquidity sometimes encourages insider trading and the majority of the transactions captured are done off the book and outside the exchange. This is the case with the NASD market in Nigeria as the majority of the transactions are done off the exchanges as stockbroking firms use their list of buyers and sellers to match potential transactions. This is an issue for individuals who want to sell because they are subject to negotiations outside the purview of market regulators.
Why liquidity is important
The first thought that comes to mind is negotiating Power. With liquidity, often times it is possible to sell your asset at per with the current market price or above the price, as there are many buyers in the market ready to take your position away from you for cash. In a situation of illiquidity, a seller’s negotiating power is weakened and will be forced to sell at a significantly lower price than the prevailing market price just so they can attract buyers.
Another consideration is time constraints. With liquidity, it is very possible to sell an asset and get almost instant cash finality into your bank account. However, in a situation of illiquidity, it could take days, weeks and in extreme cases, years to sell off an illiquid asset position. This poses a problem for individuals who are pressed for cashflow.
As great as liquidity can be for the markets, there are some, particularly long-term, investment vehicles that benefit from a lack of liquidity. Pension plans and insurance companies look to capitalize on the risk premiums associated with illiquid assets like real estate, farmland, etc., that sport long-range maturations as well as offer incentives (i.e., interest) for their increased risk. This is known as an illiquidity premium.
It is still important to remember that there is only upside to market liquidity. In fact, the financial markets need liquidity to ensure that traders can open and close their positions efficiently and enjoy tighter bid-ask spreads. To put it simply, market liquidity actually lowers the cost of investing. Hence, why liquidity is very important to consider before buying an asset.