Investors purchase many types of assets, from stocks and real estate, to collectibles and precious metals, hoping to sell those assets for a profit in the future. If the investor cannot find anyone to buy his asset when he wants to sell it, he might have difficulty converting the asset to cash. Liquidity is a term that describes how readily an asset can be purchased or sold.
Basics of Liquidity
Cash is commonly considered the most liquid type of asset, because it is readily accepted as a form of payment for almost anything and can be exchanged for other world currencies at any time. Assets that can be converted into cash easily are considered liquid assets. For example, the stock of a popular company that trades in high volume on the stock market would be a liquid asset, because you can buy and sell such stocks whenever stocks are trading.
Illiquid assets are those that are difficult to convert to cash. An asset can be illiquid for a variety of reasons, such as legal or logistical issues involved with selling the asset or a small market with few interested buyers. For instance, homes tend to be illiquid assets because sellers must expend significant effort finding buyers and going through legal hurdles, which can take months or longer if the price is too high or demand for housing is low. Stocks of small companies that do not buy and sell shares often may be illiquid. Personal property such as computers, home electronics, furniture and other items tend to be illiquid assets.
Benefits of Liquidity
It can be advantageous to hold liquid assets, because they allow you quick access to cash in the event of unexpected expenses. For example, if you have an unexpected medical expense, you might have to produce a few thousand dollars to pay your deductible. You could easily sell a liquid asset such as shares of stock in large company to cover the expense.
If your wealth is tied up in illiquid assets, you might not be able to take advantage of other investment opportunities. For example, if a certain stock is at a bargain price level, you might want to purchase it quickly, but if most of your wealth is devoted to illiquid assets, such as your home or antiques, you might not be able to convert it cash in time to take advantage of the opportunity.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.