Introduction

Not all investments can be bought or sold quickly. While publicly traded stocks and other actively traded securities can often be converted into cash relatively easily, some investments may take significantly longer to sell or may require an investor to accept a lower price to find a buyer.

Liquidity risk is the possibility that an investor will be unable to buy or sell an investment quickly at a price close to its estimated or current market value. Liquidity is an important consideration because an investment's value is not the only factor that matters—investors may also need to access their money when circumstances change.

Understanding liquidity risk can help investors evaluate how easily an investment can be traded, how market conditions can affect its ability to be sold, and how liquidity can influence portfolio management.

1. What Is Liquidity Risk?

Liquidity risk is the risk that an investment cannot be bought or sold quickly without causing a significant change in its price.

An investment is generally considered liquid when there are many willing buyers and sellers and transactions can occur efficiently. An investment is considered illiquid when there are relatively few buyers or sellers, making transactions slower or potentially more expensive.

For example, shares of a large publicly traded company may have substantial daily trading activity, allowing investors to buy or sell shares relatively easily. By contrast, a privately owned business or piece of real estate may take considerably longer to sell.

Liquidity risk can become especially important when an investor needs access to cash unexpectedly.

2. What Makes an Investment Liquid?

Several characteristics can contribute to an investment's liquidity.

These include:

• Trading Volume: Investments with higher trading volume generally have more buyers and sellers.
• Market Size: Larger markets may provide more participants willing to trade.
• Number of Buyers and Sellers: A large pool of market participants can make transactions easier.
• Bid-Ask Spread: A smaller difference between the highest price a buyer is willing to pay and the lowest price a seller will accept can indicate stronger liquidity.
• Market Accessibility: Securities traded on established exchanges are generally easier to transact than privately negotiated investments.
• Market Conditions: Liquidity can change significantly during periods of market stress.

Liquidity is therefore not always a permanent characteristic. An investment that is normally easy to trade can become less liquid during periods of financial uncertainty.

3. What Is the Bid-Ask Spread?

The bid-ask spread is the difference between the highest price a buyer is currently willing to pay and the lowest price a seller is willing to accept.

For example, suppose a stock has:

• Bid: $49.90
• Ask: $50.00

The bid-ask spread is $0.10.

A relatively narrow spread often indicates that buyers and sellers are actively participating in the market. A wider spread can indicate lower liquidity or greater uncertainty.

The bid-ask spread represents one of the costs investors may face when trading. Investors should therefore consider not only the quoted price of an investment but also how easily they can enter or exit the position.

4. Which Investments Are Generally More Liquid?

Liquidity varies significantly across different types of investments.

Generally more liquid investments can include:

• Large-cap publicly traded stocks.
• Major stock-market ETFs.
• Frequently traded government securities.
• Securities with substantial daily trading volume.

These investments typically have established markets with many participants.

However, liquidity can vary even within the same asset class. A widely traded stock may be highly liquid, while a thinly traded stock may have fewer buyers and sellers and therefore greater liquidity risk.

5. Which Investments Can Have Higher Liquidity Risk?

Some investments can be more difficult to sell quickly.

Examples may include:

• Real estate.
• Private company investments.
• Certain corporate bonds.
• Private equity investments.
• Collectibles.
• Thinly traded securities.
• Certain alternative investments.

For these investments, finding a buyer may take time. In some situations, an investor may need to accept a lower price to complete a transaction more quickly.

This creates an important distinction between value and liquidity. An asset may have substantial estimated value but still be difficult to convert into cash quickly.

6. How Does Liquidity Risk Affect Investment Prices?

Liquidity can influence the price investors are willing to pay for an asset.

When an investment is difficult to sell, investors may demand a higher potential return as compensation for accepting the additional liquidity risk. This can affect the price and yield of certain securities.

Liquidity can also deteriorate during periods of market stress. When fewer investors are willing to trade, bid-ask spreads may widen and prices can move more dramatically when transactions occur.

As a result, an investor may discover that the price they expected to receive is different from the price at which they can actually sell.

7. What Is Market Liquidity?

Market liquidity refers to how easily assets can be bought or sold throughout a market without causing significant price changes.

A highly liquid market generally has:

• Many buyers and sellers.
• High trading activity.
• Narrower bid-ask spreads.
• Efficient price discovery.
• Relatively low transaction costs.

An illiquid market may have fewer participants, lower trading volume, and wider spreads.

Market liquidity can change over time. During periods of economic uncertainty or financial stress, investors may become less willing to trade, potentially reducing liquidity across certain markets.

Conclusion

Liquidity risk is the possibility that an investor will have difficulty buying or selling an investment quickly at a price close to its current or estimated value. It is an important consideration because an investment can have substantial value while still being difficult to convert into cash.

Factors such as trading volume, market size, the number of buyers and sellers, bid-ask spreads, and overall market conditions can influence an investment's liquidity. Liquidity can also change during periods of financial stress, potentially making normally tradable investments more difficult or expensive to sell.

By considering liquidity alongside market risk, potential returns, investment time horizon, and other factors, investors can make more informed decisions about how different investments may fit within a portfolio.