If you have extra money to invest but want to ensure that you can easily convert your investment back into cash, you may wonder what liquidity is and which investment classes have the most liquidity.
Liquidity refers to how easily an asset can be converted into cash without significantly impacting its value. Investments with the most liquidity can be sold or exchanged for cash with minimal fees or loss of value. Stocks and bonds are examples of investments with high liquidity.
Building a balanced portfolio involves choosing between liquid and illiquid investments that give you a balance of flexibility and profitability.
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What factors impact liquidity?
A liquid asset can be readily accessed in an established market with a large number of interested buyers. The most liquid asset is cash on hand due to its easy accessibility and widespread acceptance in nearly all transactions.
Other factors affecting liquidity include:
- Market size and depth: To boost liquidity, invest in assets traded on major exchanges with more established markets and a large number of participants.
- Trading volume: Frequently bought and sold assets are typically easier to exchange without significantly impacting their value.
- Bid-ask spread: An asset is generally more liquid when buyers and sellers agree on its price, usually due to increased competition.
- Economic conditions: During a market downturn, liquidity may decrease across asset classes as investors become more risk averse.
- Market sentiment: If investors are hesitant to invest or trade, the liquidity of some assets may decrease even in strong economic conditions.
- Asset class: Some assets are easier to convert to cash than others.
- Regulatory environment: Certain assets may become more difficult to buy, sell, and trade due to regulations, requirements, and penalties, thereby impacting their liquidity.
- Time horizon: Short-term investments are typically more liquid than long-term investments.
- Market infrastructure: How well the trading platform performs can also impact liquidity.
- Transaction size: Larger transactions may take longer to process, which naturally decreases their liquidity.
Which investments have the least liquidity?
Investing in a private company is an example of a low-liquidity investment. Unlike cash investments or trades, there is typically a limited market for selling shares in a private company, and even if a buyer is found, regulatory restrictions can slow and complicate the transaction.
Restrictions about who can have an ownership stake in the company can limit the buyer’s market and your potential profit. It can also be challenging to assign a valuation to a company, which can make it more difficult to settle on a fair price for your shares.
Real estate is another example of a low-liquidity investment. Whether selling your home or business, you need to prepare the property, find a buyer, agree on a price, conduct inspections, make any necessary repairs, and complete the closing process.
Art and collectibles vary in value based on their desirability, and this can vary significantly among potential buyers. Current trends and market conditions can greatly impact the value of art and collectibles. This market, whether it is for buyers or sellers, can be unpredictable and subjective.
Private equity and venture capital investments typically involve a long-term commitment and demand a relatively high level of investment. Along with a cash investment, private equity investors improve the companies they invest in to prepare them for sale or initial public offering (IPO).
Uncommon cryptocurrencies can also be difficult to convert to cash. This may change in the future as the potential market increases.
What are the risks and benefits of investing in illiquid investments?
Some assets offer the potential for higher returns to compensate for their illiquidity. Investors who are willing to commit their cash for extended periods often reap higher returns on their investments. Another potential benefit is that a longer investment period can reduce the risk of market volatility impacting the asset’s value.
As mentioned, some of the biggest risks associated with investing in illiquid assets are the difficulty of pricing the asset and converting it to cash, the potential for loss in a changing market, and the difficulty of finding a suitable buyer.
If you are building your investment portfolio, consider contacting a Frame Wealth Management fee-only financial planning advisor for guidance on achieving your financial goals. We can help you create a well-diversified portfolio that fulfills your current financial needs and achieves your future financial goals.
Give us a call today at 866-973-6421 or contact us online to schedule a meeting and discuss your unique financial needs. Let us be your trusted partner on the path to financial success.
