What Is Liquidity, and Why Is Liquidity Important?
Peter Reagan

Key Takeaways

• In finance and economics, liquidity refers to how easily an asset can be converted into cash
• Cash is the most liquid asset
• Liquidity is one of the most important and least considered characteristics of any investment
• Physical gold is among the most liquid of all financial assets

Liquidity is one of those words that gets thrown out a lot in the context of finance and investing. Turns out not everyone knows exactly what it means.

I believe it’s extremely important to understand liquidity and its role in investing. So I’m going to take you on a deep dive (if you’ll pardon the pun). I’ll define liquidity, explain why liquidity is important (with examples) and talk about how we measure liquidity. By the time you finish this article, you won’t have ANY questions about liquidity…

So buckle up everybody, Professor Reagan’s class is in session!

What is liquidity?

In the context of finance and economics, liquidity’s definition is:

The ease with which an asset can be converted into cash

Well, that’s my definition. Nobel Prize-winning economist and all-around sharp thinker Robert Shiller’s take on the meaning of liquidity is:

Liquid assets are assets that resemble cash, because they can easily be converted into cash and used to buy other assets.

Or we can look to Investopedia: 

Liquidity: The efficiency or ease with which an asset can be converted into ready cash without affecting its market price.

Essentially, the more liquid an asset is, the simpler and cheaper it is to convert it into cash.

The less liquid an asset is, the more complicated and expensive it is to convert it into cash. Illiquid assets sometimes get sold at fire-sale prices. 

Quick note on terminology: When I say “asset,” I’m referring to anything worth money. When I say “financial asset,” I’m referring to the sorts of things people generally invest in. For example, a purebred labradoodle puppy is worth money – but that doesn’t make it a financial asset.

Why is liquidity important?

Financial assets are primarily just ways of storing cash until you need it. 

In the context of investing, liquidity is important for this main reason: Virtually every asset must be converted into cash in order to be useful. (There are some exceptions – your home, for instance.) 

Cash is our medium of exchange. It’s how we pay the bills and how we measure the value of our investments. Liquidity is important because it measures how easy or hard it is to turn an asset into spendable cash.

What’s the difference between liquid and illiquid assets?

In investing, liquidity risk is the difficulty of converting assets into cash without a significant loss in value.

Two key considerations come into play when we discuss liquidity. Those are markets and volume. 

Highly liquid assets

Highly liquid assets share the following characteristics: 

• They’re bought and sold publicly in one or more markets
• There’s enough volume that any seller can be confident they’ll easily find a buyer (and vice versa)
• They’re fungible (any one unit is indistinguishable from any other unit)

The combination of an active market, buy/sell volume and fungibility makes price discovery easy. 

Price discovery is the process by which buyers and sellers determine the fair market price of an asset through their interactions in a regulated exchange or marketplace. Price discovery incorporates the forces of supply and demand.

Fungibility means one example of an asset (an ounce of gold bullion or a dollar bill for example) is functionally identical to every other asset of the same price. They aren’t exactly identical – both $1 bills and gold bullion bars have a unique serial number associated with them – but their differences don’t matter.

An active market operating at volume means the asset in question is being bought and sold all the time, so its price is constantly updated as new supply and demand information becomes available. That’s why prices change all the time.

Commodities, government debt, currencies, equities, major cryptocurrencies – all these assets fall into the “highly liquid” category.

Illiquid assets

As you might expect, illiquid assets have the opposite characteristics of highly liquid assets: 

• Transactions may not be public; markets may be regional or otherwise fractured
• Volume may be low or nonexistent
• Individual assets may be idiosyncratic (unique) rather than fungible

Lack of active markets means there’s no price discovery – so an asset’s price is less likely to reflect reality. Finance nerds may have read Michael Lewis’s fantastic book Liar’s Pokerwherein traders take advantage of the lack of public markets to sell overpriced assets to unsophisticated investors. If you’re not a reader, the 2011 movie Margin Call has similar scenes.

Lack of fungibility means that valuations have to be established for individual assets. Real estate, for example – a 1,400 sq. ft. three-bedroom home in San Francisco is a very different asset than a 1,400 sq. ft. 3-br home in Detroit. And they’ll be priced very differently. 

Masterwork art, collectible cars, graded numismatic coins, office buildings and all sorts of capital expenditures (manufacturing equipment and the like) are illiquid assets. This doesn’t mean they aren’t worth money – simply that they’re harder to convert into cash.

What is liquidity risk?

LIquidity risk is defined as the chance you might not be able to sell an asset for its fair market price. The less liquid an asset is, the greater the chance you have to wait for the perfect buyer to get the best price. 

Think again about real estate. In the aftermath of the mid-2000s housing bubble, how many properties did you see that were marked down 50-75% from their last sale price? That’s because the owners were desperate for cash, and were willing to take what finance types call a haircut to move an illiquid asset.

What are the most liquid assets?

The most liquid common assets are: 

• Cash (the benchmark for liquidity)
• Gold
• Other commodities and publicly-traded equities of all sorts
• Heavily-traded contracts (puts and calls, futures and other options)

According to the WGC, gold is the third most liquid asset on the planet. Their report summarizes several reasons that gold plays such a vital role in the global financial system:

The scale and depth of the market means that it can comfortably accommodate large, buy-and-hold institutional investors. In stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of financial stress. Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, or mispriced.

Want to learn more about the vital role physical precious metals can play in your retirement savings? Interested in diversifying your savings with gold using money you’ve already saved? 

Request your copy of the Birch Gold Insider’s Guide to Physical Precious Metals – it’s 100% free.

 

 

Peter Reagan is a financial market strategist at Birch Gold Group. As the Precious Metal IRA Specialists, Birch Gold helps Americans protect their retirement savings with physical gold and silver.

 

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