Too embarrassed to ask: what is liquidity?

Liquidity is a concept that has made a lot of financial headlines in recent years. But what is liquidity, and why is it so important?

Liquidity is a concept that has made a lot of financial headlines in recent years, usually by springing nasty surprises on unsuspecting investors. For example, those who invested in Neil Woodford’s funds ran into trouble because his main fund held too many illiquid assets, leaving them unable to withdraw their funds. And at various points over the last few years, investors in certain property funds have been left unable to withdraw their cash, again because the assets inside these funds are insufficiently liquid.

So what is liquidity, and why is it so important? Put simply, liquidity refers to how easy it is to buy or sell an asset without the price moving against you.

For example, property is illiquid. It takes a long time to buy or sell. Trading costs are high. You can never be certain of the price you’ll get until the deal is done. And if you want to sell in a hurry, you’ll have to cut your price to well below the theoretical “market value”.It’s a similar story for shares in unlisted companies – hence the problem with the Woodford fund.

By contrast, shares in companies listed on the FTSE 100 are very liquid. You can get a price almost instantly, and you can almost always find a willing buyer or seller at that price.

Bear in mind that the level of liquidity in a market is not fixed. It can vary widely. In times of turmoil it may even evaporate altogether, particularly in smaller markets.In the very worst panics, only the safest assets – such as US government bonds – may remain as liquid as they usually are.

A lack of liquidity is not in itself a problem. Indeed, illiquid assets usually deliver greater returns, precisely because of the lack of liquidity.The real problem arises when you own an asset that turns out to far less liquid than you expected, just when you need to sell it.

It’s another reminder to always understand exactly what you are investing in, before you invest in it. For more on the hidden risks to watch out for with illiquid assets, subscribe to MoneyWeek magazine.

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