What is liquidity?
In the realm of investing, liquidity refers to the ease with which an asset can be traded in the market without significantly impacting its price. Highly liquid assets tend to have a lot of buyers and sellers in a market without significant legal or administrative barriers to transacting, making trade executions easy and efficient.
Liquidity provides investors with the flexibility to enter or exit capital positions with minimal impact on the asset’s market price—and they can quickly convert their assets into cash if necessary.
Examples of liquid assets include:
- Cash products
- Government securities (Treasury bills and bonds)
- Blue-chip publicly traded stocks
- Certain commodities like gold and silver
Illiquid assets, on the other hand, have more limited trade volume. Transactions involving illiquid assets may take longer to execute because of regulatory requirements or market transaction infrastructure, or because of the natural time horizon of an investment’s potential yield. These longer term considerations can potentially create space for bigger price fluctuations in the asset, both up and down.
Illiquid assets may take longer to trade for a few reasons:
- Smaller pool of potential buyers and sellers, which makes it more challenging to find interested counterparties
- Complex valuation due to a lack of price transparency, which can prolong negotiation
- Wide bid-ask spreads (the difference between the highest price a buyer is willing to pay and the lowest price the seller is willing to accept)
- Legal and regulatory constraints
- Perceived risk, which can reduce demand and lengthen trade execution times
Examples of illiquid assets include:
- Private equity
- Fine art
- Collectibles
- Non-publicly traded real estate investment trusts (REITs)
- Fine wine and rare spirits
- Venture capital