Skip to main content

ELI5: What is Liquidity?

Four White Sale Boards

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.


Comments

Popular posts from this blog

Today's Special: Humble Pie

You champion a project, fight for an idea, and then...reality sets in. That churning in your stomach isn't butterflies, it's the realization you've missed the mark.  Pride will puff up your chest, and kick in the "defend at all costs" instinct. But arguing with the umpire never changed a call. Admitting you're wrong isn't a sign of weakness. It can strengthen your professional standing. In a world obsessed with the illusion of infallibility, the courage to adjust course is a breath of fresh air. It shows you're confident enough to be wrong, and adaptable enough to learn from it. Do your research, think critically, and stand behind your decisions. But when the data whispers (or screams) otherwise, don't be afraid to swallow that slice of humble pie. Be the first to acknowledge. Don't wait for someone to point out your mistake. Be open, take responsibility, and most importantly, focus on what you're going to do to address it. Don't dwell ...

Negative Feedback, Positive Lessons

In the battle against plastic bags, a five-cent tax was shown to be much more successful at deterring usage than a five-cent credit for bringing your own bags. Carrots satisfy but sticks sting, and they sting hard. So we default to the less painful choice of avoiding loss. Loss aversion impacts the way we process information. A 2019 study  invited participants to learn through a series of multiple choice questions. Each question only had two options to choose from. Whether guessing correctly or not, they would still learn the right answer.  Despite the identical learning opportunity, participants were much more successful at recalling the answers they guessed correctly than those they got wrong.  "You're right!" feels good. We savour the moment, analyzing every detail.  "You're wrong!" stings. We want to quickly forget, dismiss, and move on.  When we succumb to loss aversion, we miss opportunities to learn. Failure is part of the process. We'll experie...

Starting Really Really Small

On your desk is one of the most intimidating sights known to man. A blank page. The prospect of filling it up with anything resembling decent seems insurmountable. Staring at the long road ahead fills you with anxiety and dread.  The first step is the most difficult. So we procrastinate. We " research ", we " prep ", we " plan ". We do everything except tackling the problem. We avoid the pain for as long as we can.  To make a blank page less intimidating. Tear it in half. There, half as scary, twice as easy. Still too much? Do it again. And again. Keep doing it until the task is so small that it's too easy not to do.  Getting starting is the hardest part. So make the hardest part as easy as possible. This doesn't guarantee amazing results, but it gets you in the game. You can't win if you don't play.