Liquidity Definition

Liquidity is the term used to describe how easily a given asset may be converted into cash. As the most liquid asset, cash is the benchmark for measuring asset liquidity. The reason for this is because of how simply and easily it can be used. After all, cash has the same value to virtually everyone!

Compare this to a rare oil painting from the 19th century. While the item may have incredibly high value to collectors, it is not a very liquid asset, because there simply aren’t many potential buyers. Selling an illiquid asset like this – yes, even a work of art – is therefore much more difficult, and usually takes far longer as a result. It may also require the expenditure of resources. An owner of real estate may decide to secure the niche expertise and contacts of an estate agent to sell a house, for example.

Liquidifying Our World

Liquidity may seem like a niche financial term, but the concept it denotes has shaped the world in which we live. The difficulty of managing varying asset liquidity was the driving force between our switch from a bartering economy to a currency-based one. Currency solved many problems, as it is liquid enough to allow everyone access to the goods and services they need. Put another way, with cash you can fill your grocery basket without any fuss. With a large oil masterpiece, it seems you can only bewilder checkout assistants.

Liquidity In Investment

Liquidity is also a key consideration for an investor to make before buying a given asset of any class. After all, it is all well and good to expect an asset to rise in value, meaning a potential profit for a buyer. But what good is that price rise if it cannot be sold in time to capitalise before the value tumbles again? Indeed, liquidity is one of the key reasons why blue chip and money market stocks are so well coveted; they are two examples of financial instruments which easily convert into cash. Any increases in asset price may be quickly and easily turned into profits for the holder when they choose to sell.

However, there is often a trade-off to be made with this ease of sale: the amount of money which stands to be made from a given asset. This is because illiquid assets tend to be more valuable – in fact, the exorbitant prices they demand can contribute towards them being illiquid in the first place! A captured 1% profit on the sale of your house or your Mona Lisa original is going to line your pockets far better than a 1% profit on a stock could. But there’s no prizes for guessing which is going to be more of a pain to sell…

Comparing The Liquidity Of Instruments

Liquidity is perhaps best imagined as a spectrum of assets. At one end, the assets easily convert into cash. At the other, the assets have such a niche pool of buyers that conversion into cash may take a while. As mentioned, cash, blue chip and money market stocks, and so called ‘store of value’ commodities like gold or silver, are all very liquid assets. Savings bonds would probably follow these on the scale, as banks are often quite happy to purchase these. Then follows the more common financial instruments: stocks, bonds, options and commodities. All of these are considered quite liquid, and mercifully so – the stock market would be fairly stale if they weren’t! You may sometimes hear very liquid assets referred to as ‘cash equivalents’, due to the readiness of markets to exchange them for cash.

At the other end of the scale, examples of illiquid assets (less liquid) are small-cap stocks, the equity in private companies and certain types of derivative contracts, which change hands rather infrequently. Illiquid assets are those with low trading volumes. Quantitative easing works because the central bank purchases illiquid assets like junk bonds from financial institutions, which theoretically gives them more cash to lend out increasing credit supply and liquidity. Other examples of illiquid items are coins, stamps, art and collectibles. A common form of an illiquid asset would be real estate. You can’t just decide to move house, sell it, buy another one, and move the very same day. On the other hand, you can easily pop down to the shops and exchange your cash for goods and services of your choice. This, in the simplest possible terms, is the difference between illiquid and liquid assets.

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