Liquidity is a financial term that describes how easy it is to cash out of an investment. Sometimes investors need to be able to sell their assets quickly in order to react to changing market conditions, such as a falling stock price or rising interest rates. A number of assets can pose liquidity problems for investors, including bonds and real estate. While there are no legal requirements for investors to hold liquid assets in their portfolio, some advisers urge investors to avoid some liquidity risks by keeping a properly balanced portfolio.
Investors face two kinds of liquidity risks: funding risks, where cash flow runs short, or liquidation risk, where there are too few buyers for an asset. According to Merrill Lynch, investors should preserve some liquidity in their portfolio in order to react to investment opportunities in changing market conditions. For example, an investor with too many of his assets tied up in real estate and bonds may not be able to take advantage of a bull stock market because he lacks the cash to buy the shares.
Liquidity in Stocks
Stocks traded on the major exchanges are among some of the most liquid investments, though investors could have trouble selling rapidly declining stocks in time to stave off serious losses, according to U.S News and World Report. Over-the-counter stock and small-capitalization (small-cap) stocks, such as penny or "micro-cap" stocks, can also face liquidity issues, according to SmartMoney. With some small-cap stocks, the liquidity risk comes when an investor owns too large a quantity of a small-cap, or "thinly traded," stock, and simply the act of trying to sell the shares causes the price to drop.
Real estate is another investment that can pose liquidity risks. Even if a house, building or plot of land has a high value, it could take too much time to complete the sale. Stable investments like a 10-year certificate of deposit or bonds can also be "illiquid" assets because of the amount of time these investment vehicles need to hold onto cash. Foreign investments, such as currency or company stock, can also pose liquidity risks, according to the Financial Industries Regulatory Authority (FINRA).
A balanced portfolio and asset allocation are central to avoiding liquidity risks, according to FINRA. Investors should determine their cash flow needs, including personal living expenses and future investment plans, to establish liquidity goals, then balance those goals with expected investment returns. How much liquidity risks an investor wants to take depends upon their strategy and personal finance needs. For example, if you plan to send your child to college next year, it may not be the time for a real estate investment that ties up cash that will be needed for tuition and boarding.
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