ELI5: What is Liquidity?

Liquidity is a term frequently used in finance. Today we'll break down what it means and why it's important.

What does it mean?

Liquidity describes an asset's ability to be sold quickly for its fair value. The more liquid, the easier to exchange for cash.

Cash is the most liquid asset because, well...it's already cash.

What makes something liquid?

Liquid assets have liquid markets, and liquid markets have two features: transparent prices and a healthy community of buyers/sellers.

For example, Apple stock has a liquid market. It's listed on the NASDAQ stock exchange (allowing for transparent prices) and trades an average of 32.2M shares a day (healthy trade community). Apple stock, like all popular stocks, is a liquid asset.

Illiquid Assets

On the contrary, illiquid assets have illiquid markets, making it difficult for them to be sold quickly at their fair value. The fair value point is important. Discounting something deeply to encourage sales does not equal liquidity. You can sell (almost) anything quickly if you slash the price enough.

Illiquid assets are typically thought of as physical assets. Art, collectables, real estate, electronics, etc. However, stocks can also be illiquid. Penny stocks (stocks for really small companies), don't trade on major stock exchanges and have very few buyers, making them illiquid.

Characteristics of illiquid assets include:

Difficult to value - There might be a big difference between what you think your Spiderman comics are worth and what buyers are willing to pay.

Small number of buyers - If your asset is niche, it could take a very long time before you find a buyer.

The need for third parties - Such as professional appraisers to determine value, brokers to facilitate trading, delivery folks to handle logistics, and the list goes on.

As you can see, there's a lot more friction when it comes to selling illiquid assets.

Keeping it Real

Understanding the liquidity of your assets allows you to paint an accurate picture of your financial health. Not evaluating the liquidity of your assets could have you overstating your readiness for financial emergencies. If you have a million dollars worth of sneakers that you can't sell, don't act like a millionaire.

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