Video FAQ: Liquidity 101

In this video, we review the basics of liquidity within investments.

Liquidity refers to an asset that has a ready and waiting market on both sides of the buy-sell equation. If you are selling and there is liquidity, then you most likely will find a buyer willing to pay a fair price. This means you won’t be stuck holding the investment at a time when you need cash.

To compensate for the lack of liquidity, investors often demand a higher rate of return on money invested. That is, investments that can’t be easily sold will generally demand a higher rate of return compared to a similar investment in a highly liquid market. Therefore, high-quality investments with lots of liquidity typically won’t pay the highest rates of return.

A Look at an Historical Example

In the Great Recession one of the reasons for the losses suffered by financial firms was the fact that these companies owned illiquid securities tied to the housing market. When they found themselves without enough cash to pay the swaps on these securities and wanted to sell these assets, they discovered that the market had dried up completely. As a result, they had to sell at any price they could get—sometimes pennies on the dollar.

In Retirement, Protect Yourself from Liquidity Risk

Never buy long-term investments that are illiquid unless you can afford to hold them for a long time or through “worst-case scenario” situations. Obviously, if you might need cash in six months, don’t buy a 5-year lock-up in an investment.

If you are interested in investing in illiquid securities, do the research—look at the company’s debt refinancing plans and work with your financial advisor to understand the risk of the asset to your cash-flow and liquidity needs. This is very important when it comes to developing a well-built portfolio that will meet your long-term and short-term goals.