Liquidity

The more, the better.

Dec 23, 2015 at 12:24AM

Liquidity is the extent to which an asset can be bought or sold quickly without affecting the asset's price. An asset that can be sold rapidly for its full value is said to be highly liquid. Whereas an asset that takes longer to sell, or one that can only be sold at a discounted value, is considered less liquid, or illiquid.

Cash is considered the most liquid asset possible because it can be instantly converted or exchanged for other assets. If an individual is looking to buy a car, for example, and has $20,000 sitting in cash, that person can simply visit an auto dealership, hand over the money, and leave with a vehicle without having to worry about having that $20,000 lose value in the process.

Real estate and collectibles, by contrast, are considered to be relatively illiquid because they generally can't be immediately converted or exchanged for other assets. Let's say someone is looking to buy a car and needs to sell a painting previously appraised at $20,000 to purchase it. That person can't just offer up the painting in exchange for a $20,000 vehicle. Rather, the person will need to go through the process of finding a buyer, which could take weeks or months. Furthermore, the person may get an offer of only $15,000 for that painting, even if it was originally worth $20,000, thus making it a fairly illiquid asset.

It's important for individuals to hold at least some assets that are fairly liquid. An emergency fund, for example, should be highly liquid so that money can be accessed immediately if a need for cash arises.

Market liquidity
Market liquidity refers to a market's ability to accommodate the sale or acquisition of an asset without significantly changing its price. In a liquid market, the quick sale of an asset shouldn't cause its price to drop drastically, whereas in an illiquid market, selling an asset quickly could result in a substantial price reduction.

The stock market, for example, is considered to have high market liquidity because of its trading volume. If there are enough people looking to buy and sell securities on any given day, there's a strong likelihood that a person looking to sell a stock will receive an offer that's reasonably close to the asking price.

If the difference between the asking price and the ultimate sale price of an asset is nonexistent or insignificant, then the market is said to be fairly liquid, but if there's a more notable difference between an asset's asking price and sale price, the market in question is said to be less liquid. The real estate market, for example, is generally considered less liquid than the stock market because it tends to see greater gaps between asking and sale prices on a whole. 

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