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Apr 26, 2018

What Is Liquidity?

By Stash Team

It simply has to do with the ability to buy or sell your investments.

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In the simplest terms, liquidity refers to how quickly an investment can be sold without having an impact on its value. It has to do with your ability to convert an asset into cash, and the speed at which you can do so. 

Actual liquid can be a useful metaphor for understanding what liquidity is in terms of markets and finance. You can think of an investment, or any financial asset, like it’s an ice cube. If you have an ice cube, then liquidity is the amount of time and effort it takes to melt that ice cube into water. The faster your investment ice cube can turn into cash, the more liquid that investment is. 

So, for an investment like a stock or bond, liquidity is a measurement of how long it takes you to sell it for cash, or liquidate it.

Assets can have varying levels of liquidity. The degree to which various investments, including stocks, are considered liquid assets depends on a few different factors. And markets themselves can also be described as liquid or illiquid. Read on to learn more about liquidity, liquid assets, and market liquidity.

Liquid assets

Assets that can be converted quickly and easily into cash are said to be liquid. In fact, cash itself is considered the most liquid of all assets, because you don’t need to convert it in order to spend it. The money you have sitting in a checking or savings account is very liquid, too, because the funds can be quickly and easily accessed in case of an emergency, or even if you wanted to seize a market opportunity. For example, if your car breaks down and you need money to pay for repairs, cash can be withdrawn from your savings account at a bank or, often, an ATM.

But when it comes to money you’ve invested, you may wonder what counts as a liquid asset. For example, are stocks considered liquid assets? What about bonds and funds? The answer is that they all have varying levels of liquidity. 

Publicly traded stocks are considered liquid assets in most cases, as they may be sold on exchanges nearly instantly for the current share price, and you generally receive the cash within a few days. In other words, it doesn’t take very long to melt the ice when you sell it. Many types of bonds can be relatively liquid as well because they can be sold on the secondary market before they mature. 

Other types of assets that are often considered fairly liquid include mutual funds and exchange-traded funds (ETFs), although they can be less liquid than stocks and bonds. Mutual funds, for example, can only be sold at the close of the trading day, and some of them have rules that restrict your ability to sell them immediately. And while ETFs can be easier to sell quickly, you might take a loss on the value of the investment if you sell in a hurry.

In contrast to liquid assets, some investors put money into illiquid assets, such as real estate or collectibles, which tend to take far more time and effort to convert into cash.

Liquid assets

Assets that can be converted quickly into cash are said to be easily liquidated. They’re also commonly called liquid assets, meaning that, again, they can quickly be converted cash.

In fact, cash itself is considered a liquid asset, as is the money you have sitting in a savings account. The idea is that the asset can rapidly be converted and accessed in case of an emergency, or even if you wanted to seize a market opportunity.

For example, if your car breaks down and you need cash to pay for repairs, cash can be withdrawn from your savings account at an ATM, making your savings account, in effect, liquid.

Market liquidity

Markets can also be described as liquid.

In a liquid market, assets are relatively easy to sell. Conversely, in an illiquid market, bid-ask spreads are larger, and selling an asset requires more work. It’s more difficult, in other words, to convert an asset into cash.

Good to know: Often you’ll hear about something called the bid-ask spread –which is the difference between the highest price a buyer is willing to pay for an asset, and the lowest price for which it will sell. The bid-ask spread is small in liquid markets, and high in illiquid markets.

That’s because, in a liquid market, it can be easier to buy and sell assets due to a higher volume of buyers and sellers. More potential buyers translate to the higher level of liquidity for your assets.

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