What Does the Term "Illiquid Investment" Mean?

By: , Contributor

Published on: Nov 12, 2019

Here's what liquidity is and why investors should care.

What is an illiquid investment?

First, let's start with the definition of a liquid investment or asset. A liquid asset can easily be sold without a major impact on its value. We'll get into more detail in the next few sections, but stocks are a great example of a liquid investment. Thanks to the magic of online stock brokers, you can sell a stock you own almost instantly and for its full market value (or within a few pennies of it).

On the other hand, an illiquid investment is one that you cannot readily sell or that you'd need to sell at a deep discount relative to its market value.

There's quite a bit of gray area in that definition, and there's a broad spectrum when it comes to illiquidity. Some investments can be readily sold, but you may have to offer a significant discount to sell them quick. Other types of investments may have no liquid market whatsoever.

For this reason, I classify most investments in one of three categories:

1. Highly liquid investments

A highly liquid investment is one you can sell quickly and with little or no impact on its value. I already mentioned stocks as an example of a liquid investment.

In addition, savings accounts, Treasury securities, mutual funds, money market funds, and publicly-traded real estate investment trusts are liquid investments.

2. Somewhat liquid investments

I consider investments to be somewhat liquid if you can readily sell them but you may have to wait a while to get full market value.

Real estate is a great example. If you own a home, you can stick a "for sale" sign in your front yard whenever you want. Getting full market value for your home can be another story. It's not uncommon for homes to sit on the market for months if the homeowner wants to get maximum value, and it's sellers often price their home significantly below market value if they want a quick sale.

Precious metals are another example of a somewhat liquid asset. The same can be said for most physical assets like vehicles, jewelry, and artwork, just to name a few. You're free to sell these whenever you want, but it might take a while to get a fair price.

3. Highly illiquid investments

On the most illiquid end of the spectrum, there are some investments that you simply cannot sell or can only sell at predetermined times (and often for a discount).

Crowdfunded real estate investments are an example of a highly illiquid asset. Once you commit your money to a crowdfunded real estate deal, you're typically locked in for the duration. If the project takes five years to complete, that's how long your money is likely to be tied up. There are no secondary markets for these types of investments (at least not yet).

Private REITs are another example. These can often only be sold at very specific times and for less than their intrinsic value, especially if you sell them shortly after buying. Private equity investments are also in this category, as there generally isn't a market for shares of non-traded companies.

Liquidity should be a major consideration when choosing real estate investments

When you're choosing real estate investments, liquidity should definitely be a part of your analysis. Crowdfunded real estate investing has the potential for high returns, but you need to accept that you're in it for the duration. On the other hand, publicly traded REITs have somewhat lower targeted returns, but you can easily sell them.

Obviously, there's a lot more to consider when evaluating real estate investments, but liquidity should be included. Keep it in mind when analyzing whether a particular real estate investment is appropriate for you.

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