What is... | November 22, 2011

What is liquidity?

In simple terms, liquidity refers to how quickly and cheaply an asset can be converted into cash. But there is more to this important term.

Since the start of the global financial crisis in 2007, one of the questions that has dominated investors’ minds is whether a debt-laden country or company is illiquid or insolvent. It may be solvent because it has more assets than debts – but it can still have a liquidity problem if it cannot access money quickly enough to pay its immediate bills.
The same distinction applies to individuals, who can learn lessons from troubled institutions and alter their behaviour so as to avoid a similar fate.

Liquid, liquid everywhere
The simple definition of liquidity refers to how quickly and cheaply an asset can be converted into cash. However, 58% of the respondents to an eZonomics poll did not know that.
While the money in your pocket and your bank account are very liquid, rare items such as stamps and art are considered illiquid because they are hard to sell at short notice. Even some investments designed to pay out at a predetermined date in the future, such as a fixed-term deposit, should be considered illiquid as they can be difficult or costly to turn into cash quickly. Shares in big companies on major stock exchanges are usually reasonably liquid as are most units in collective investment vehicles such as mutual funds or unit trusts. Be aware, however, that fees can apply to convert these types of investments into cash.
Ironically, wine investments are often not liquid.

Go with the flow
High personal debt levels and low savings rates have fuelled concerns that many households are not keeping enough money in liquid assets. One reason may be that people underestimate the chances of suffering the slings and arrows of outrageous fortune. Economists call this an overconfidence bias, as Dutch research explains. It found that people who had not been exposed to a liquidity problem in the past were more likely to underestimate the risk of being affected in the future. It is a similar to the argument that investors’ appetites for financial risk are shaped by formative experiences.
ING Group chief economist Mark Cliffe explains in his third video lesson from the financial crisis that it may be worth accepting lower returns in order to have more liquid investments.

Revenue streams
There are good reasons why we don’t hold all our wealth in cash, in the bank or under the bed: it does not pay much interest - especially in the current era of low interest rates. Higher returns can sometimes be made in return for locking money away, such as in fixed-term savings or in rare assets that are hard to sell.

Yet being liquid need not mean accepting poor returns. Individual shares and mutual funds are often liquid but involve the risk of losing money. However, in general, higher liquidity is associated with lower investment risk and, therefore, lower likely return.

Bird in the hand
People often keep money aside for a “rainy day”, that is an emergency requiring access to immediate funds rather than having to pay to get hold of funds. For example, household repairs may require money quickly.
Having to sell illiquid assets such as a car or jewellery quickly to raise cash can mean receiving less for the item because the buyer knows the seller wants immediate cash rather than the best price.
This is why massive price cuts by struggling companies are known as “liquidation” sales.

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Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics