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investingforbeginners.eu Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed.
Benjamin Graham

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Liquidity

 

(1) Market liquidity is a characteristic of a security or other traded investment that shows how easy it is convertible in to cash at a market value. Usually when investor decides to sell some investment and turn it in to cash, it takes some time. The quicker investor wants to sell his investment the more losses he has to face. Of course, different investments have different liquidity.

 

This is an important characteristic for every investment because high liquidity means higher risk for the investor. For example, if financial crisis will appear and investor will be needed for cash (maybe lose his job) and all of his investments will be illiquid, then he will be forced to sell those investments at a huge discount to find any buyer. The faster he will be needed to sell an asset the higher discount must be offered.

 

Different assets have different liquidity. For example all blue chip stocks have the highest possible liquidity and large stock stakes can be sold in minutes or hours (of course, if stock exchange is open) without strong affect to the price. But not all the stocks are very liquid. Some penny stocks or stocks in undeveloped markets as Ukraine or similar may have very low liquidity and spread between ask price and bid price may be us much as 20% or sometimes even more. Real estate is also classified as very low liquidity investment.

 

To measure the liquidity of stock or other security two parameters should be measured: spread between bid and ask prices and trading volume. To measure liquidity for other investments that aren’t traded at stock exchange is a harder task, and only professionals of a particular market can tell that. 

 

Most liquid assets:

  • Currencies (as a cash investments) and other money market investments
  • Blue chip stocks or other stocks, that that have large free float
  • Commodities that are traded on exchange
  • Bonds that are traded in large turnovers

 

However, in reality liquidity may have some exceptions. For example you may have some funds in savings account but if that bank will be stopped for restructuring or bankruptcy, then your savings can be frozen for quiet long period or even worse: you may lose some of the deposit value. The same may happen for stocks or other securities if the stock exchange is closed for weekend or longer period during stock market crash (this is more probable in emerging markets).

 

(2) Financial liquidity may also have another meaning. Here it may mean company’s ability to pay its current liabilities and is a part of financial analysis. To measure company's financial liquidity, these liquidity ratios should be used:

  • Current ratio
  • Quick ratio
  • Cash ratio

 

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