Liquidity and solvency are two completely separate concepts, but it's good to invest in companies that have both. Liquidity is the ability to change assets into cash. It's sometimes easier said than done, because sometimes assets, such as real estate or financial securities can take years to unwind, or transform, into cash. Without solvency, a company is deep in debt and doesn't have enough cash or other assets to cover its financial obligations.
The most severe risk associated with liquidity is not having any. You run head on into this risk if you invest in a financial asset that can't easily be converted to cash. You may also have a position in a mutual fund or hedge fund that can't just undo its trades. When you're invested in illiquid securities, you better have a backup plan, because your money could be tied up for years. Investing in insolvent regions or securities is worse, because basically there is not enough money coming in to pay what's owed.
Stocks are the most common asset class and are generally liquid investments. As long as there is enough demand to meet supply, you should have no problem selling. Some stocks, however, are less liquid than others. According to a 2010 "Smart Money" article, in the more-than two decade period leading up to 2010, less-liquid stocks outperformed more-liquid equities by about 5 percent. Insolvent companies, on the other hand, usually file bankruptcy and often don't have anything left to leave equity investors once creditors are repaid.
When companies decide to issue bonds, they have to budget for the interest payments investors come to depend on. If they don't do it right and find themselves without liquidity, they could default on their bonds, and investors could go unpaid. Luckily, corporate bonds are often rated, so you can decide for yourself if an investment is worth the risk. If a bond issuer becomes insolvent and winds up in bankruptcy court, cash may still be uncovered with asset sales. Bond investors get paid before stock investors when a company becomes insolvent.
Liquidity and solvency don't only concern your investment portfolio. They are also relevant to the overall economy. In 2008, when the U.S. economy was crippled and financial institutions stopped lending, it was a combination of both a liquidity and solvency crisis. To fix it, federal policymakers gave liquidity to banks using cash, but that alone was not enough to identify the insolvent banks, according to a 2011 article in "The Economist." While liquidity can help to keep an economy afloat, it can't fix the more deeply rooted issue of insolvency.
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.