Liquidity relates to how easily investments can be traded
The meaning of liquidity is a mystery to more than half of respondents to this poll – but a few moments learning how this concept works could pay dividends. Put simply, liquidity relates to the ease at which investments can be brought or sold. Assets that can be traded easily are known as liquid assets, while those that are more difficult to cash up are “illiquid”. Financial website Investopedia goes a step further adding that liquidity relates to the ease at which investments can be traded “without affecting the asset’s price”.
Cash is liquid, but wine is usually not
Liquid investments include the likes of cash on call at the bank and shares in large companies quoted on major stock exchanges (which are in high demand). Many large collective investment vehicles such as mutual funds can also be described as liquid – but, like most investments, conditions can change that impact the ease at which investors can sell. On the other hand, illiquid investments might include fixed term deposits at banks (because it is hard to take money out without affecting the interest due to be paid) and specialist investment funds such as private equity. Alternative investments, such as stamps, art or wine, likely have a small market, so can be hard to sell. Property is more difficult to classify as it can go through periods of high demand – only for the market to suddenly fall away.
The importance of liquidity
ING Group chief economist Mark Cliffe detailed the importance of liquidity in his third video lesson for investors from the financial crisis. In it, Cliffe discussed problems faced by money market funds in the downturn and troubles some investors had selling real estate.
“The credit crunch is a reminder that investors need to think about who they will ultimately sell their investments to,” he said. “It might be worth paying a bit more for more liquid investments.”
Planning investments can help protect from problems with liquidity – with money needed within months perhaps best moved less liquid to more liquid investments ahead of time.