Let’s play out a scenario.
One Sunday you sit to chalk out your net worth and come away fairly impressed.
For one, you own an apartment which you give out on lease. The rent from the latter gives you a fairly steady income (in addition to your own monthly salary) and the property only grows in value over time.
A beautiful masterpiece by a world-renown artist adorns your wall. You might have paid a tidy sum to own it and then spent more to insure it. You won't get a steady stream of income by way of dividends or rent. But you are certain that this painting will fetch you a jaw-dropping price when you decide to sell it.
Soon an unfortunate financial emergency befalls you and you need cash urgently. You will immediately realise that you cannot sell the painting so easily. Apparently half the market is traded privately. Also appraisals must be made and buyers must be approached and courted. This will take time and you don’t have time. But you would have gained an instant understanding on why art is an illiquid investment.
Liquidity refers to how easily an asset can be sold for cash without the sale affecting its price.
So let’s say you decide instead to sell the apartment. To get the price you are asking, you may have to wait for weeks and months before the right buyer comes to your doorstep. Sure, you can sell it quite quickly if you lower the price sufficiently. But if you have to knock off a substantial amount off your desired asking price just to get traffic in the door, then that does not make it a liquid asset either. It is not just how easily it can be sold, but how much a quick sale will affect its price. The more you have to lower the price, the less liquid the asset really is. Real estate too is not a very liquid asset.
For this reason, at least some portion of your portfolio must be liquid. It is what financial planners refer to as an emergency fund. Money here will be kept in a savings account or a liquid fund or a bank fixed deposit.
Every investment you make requires you juggle between risk, return and liquidity.
In the case of the emergency fund, you would look for high liquidity and low risk. Of course the trade-off will also be a lower return.
On the other hand, when you buy property, you are looking at low risk and a fairly high return – by way of rentals and appreciation. You will have to compromise on liquidity though, as the above example exemplifies.
If you are investing for the long term, you want a higher return and so are willing to go with stocks or equity mutual funds. They are liquid too but you take on more risk.
One component of liquidity is the speed at which you can perform a transaction—the time elapsed between when you put up the asset as a seller and when you find a buyer. In this sense, stocks are very liquid investments as they can be traded on any working day on the stock exchange. Millions of transactions take place daily and the market activity on the stock exchange sets the price for the stock.
The other component of liquidity is the ability not to take a price hit. Here, stocks could falter. After all, if you are selling when the market is in the doldrums, you will get your money quickly but not at the rate you would have desired. Or, it could be that the market is on a roll but you are selling small cap stocks which are not in demand at that point in time. In that sense, blue chips are more liquid than small caps.
A liquid investment is easy to cash up; an illiquid investment is difficult to sell without taking a price hit. It’s not at all wrong to have illiquid assets. But they are worth it if you don’t need to sell them to bail you out of an emergency. Such investments are great if you can hold on to them till the opportune moment when they have appreciated in value.
It’s just as vital to have some wealth in assets that you can sell quickly if needed. So should a medical emergency come up, or should you lose your job, the liquid portion of your portfolio can help you sustain that period and you need not derail your entire investment plan.
Liquidity, unfortunately, is an investment attribute that slips below the radar for many investors, only to be sharply reminded of its importance during an emergency.
