What is liquidity and why it matters to investors
Guide Summary
- Liquidity refers to how easily and quickly an asset can be converted into cash or invested in without affecting its market value.
- Highly liquid markets and assets provide more flexibility, lower transaction costs, and smoother trade execution.
- Understanding liquidity helps investors manage risks and align their portfolios with both short-term and long-term goals.
What is liquidity?
In finance, liquidity describes how quickly you can sell an asset and turn it into cash at a similar market value.
Assets with liquidity, like publicly traded shares, can usually be sold almost instantly. Illiquid assets, like property or rare collectibles, may take weeks, months or even longer to sell.
Understanding how liquidity works
Imagine you own a watch. If it’s a popular brand and model, you can likely sell it quickly at a fair price. This is a liquid asset. But if it’s a niche, custom-made piece, you may struggle to find a buyer willing to pay a reasonable amount, making it illiquid.
In investing, the same principle applies. A company’s shares listed on a major exchange are easy to sell due to high demand. But a privately held company share may be hard to sell — even if it’s valuable — due to low market interest. Understand stock market basics.
What is market liquidity?
Market liquidity refers to how easily assets are bought and sold in a particular market. A liquid market has lots of participants and more stable prices.
In contrast, an illiquid market sees fewer transactions, and more volatile prices.
For example, major stock exchanges in the UK (like the London Stock Exchange) tend to be highly liquid, whereas niche bond markets or alternative investments may not be.
How to measure liquidity
Liquidity isn’t just a feeling, it can be measured using specific indicators. These include:
- Bid-ask spread: The smaller the difference between buying and selling price, the more liquid the asset.
- Trading volume: Higher volume generally means more liquidity.
- Turnover ratio: How frequently an asset is traded relative to its total number of outstanding units.
- Time-to-cash: How quickly an asset can realistically be sold.
In broader financial markets, indicators like the Liquidity Coverage Ratio (LCR) are used by institutions to assess liquidity under stress. LCR is the minimum amount of highly liquid assets that financial institutions are required to hold by international regulations.
Understanding how liquidity varies across asset classes
Not all investments are equally easy to buy or sell. Liquidity can vary significantly depending on the type of asset, and understanding these differences can help investors make smarter choices based on their goals and time horizon.
- Cash and cash equivalents, such as savings accounts or money market instruments, are the most liquid assets. You can typically access your money almost instantly, with little to no loss in value.
- Publicly traded shares, like those listed on major stock exchanges, are also highly liquid. They can usually be bought or sold quickly during market hours, with plenty of buyers and sellers ensuring fair pricing.
- Government bonds are generally considered liquid, especially in developed markets. However, they may be less liquid than shares depending on the issuer, maturity and market conditions.
- Real estate is a classic example of an illiquid asset. Selling a property can often take months, involves significant transaction costs, and can be heavily influenced by market conditions.
At the far end of the spectrum, private equity, venture capital and collectibles (like fine art) are among the least liquid investments. They may take years to exit and often have limited secondary markets.
For new investors, starting with more liquid assets provides greater flexibility, especially if you need access to funds in the short term. As you gain experience, you might explore less liquid opportunities, but it's important to understand the trade-offs in advance. Learn about passive and active investing.
How can liquidity affect investment strategies?
Understanding what liquidity is helps influence investors with making investing decisions based on their own personal financial situation. This could include:
- Portfolio design: Investors may avoid illiquid assets if they anticipate needing cash soon. What is portfolio management?
- Risk management: Liquid assets are easier to sell in a financial crisis, such as a recession.
- Returns: Illiquid assets sometimes offer higher potential returns to compensate for added risk, this is known as the liquidity premium.
New investors should balance liquidity needs with return goals, especially if they’re building emergency funds or planning for short-term goals.
Liquidity and investing summary
Liquidity plays a central role in how markets function and how investors manage risk and opportunity.
Whether you're buying your first shares in an ETF or considering diversifying into alternative assets, understanding liquidity helps you make informed, confident decisions.
In the next guide, we’ll explore economic indicators investors should know, diving into how market data can signal future trends and help guide your investment strategy,
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation.
