Liquidity, or the lack thereof, known as illiquidity, is one of the most commonly overlooked factors when investors evaluate an asset’s desirability. While price stability, historical performance, and growth potential are all worthwhile considerations, the ease of converting an investment to cash at a fair market value shouldn’t be ignored.
This characteristic can influence the flexibility of a portfolio which is crucial when responding to rapid market fluctuations or last-minute developments in your finances. Understanding the difference between liquid and illiquid assets can help investors compile the most dynamic nest egg based on their specific goals.
Understanding Liquid Assets
Liquid assets, sometimes referred to as cash-equivalents or near-cash assets, are investments that can be converted into their fair market value fairly quickly. For an investment to be considered liquid, there needs to be reliable demand, active buyers, and a streamlined selling process. The US dollar is the quintessential example of a liquid asset because converting money in your bank account into cash is as simple as using an ATM. Stocks, ETFs, government bonds, and treasury securities are also considered to have high liquidity. Investors can easily offload these while maintaining most of their value.
Examples of Liquid Assets
- Cash
- Certificates of deposit (CDs)
- Banking accounts (checking, savings, etc.)
- Exchange-traded funds (ETFs)
- Government, corporate, and municipal bonds
- Mutual funds
- Stocks of publicly traded companies
- Treasury bills
- Physical gold
Understanding Illiquid Assets
Illiquid assets, also referred to as nonliquid or fixed assets, are investments that cannot easily or efficiently be converted into cash without losing some of their value. In other words, trying to offload these assets quickly often results in a financial loss. In contrast to the conditions that boost an asset’s liquidity, fixed investments face limited demand, unstable markets, higher transaction fees, and complex or prolonged settlements. Some examples of illiquid assets include real estate, businesses, vehicles, and even art pieces. Selling these assets promptly without sacrificing ROI tends to be more complex, tedious, and challenging. Investors holding fixed assets must plan for longer holding periods and more complicated transaction processes.
Examples of Illiquid Assets
- Fine art
- Collectibles
- Hedge funds
- Intellectual property rights
- Jewelry
- Private businesses or shares in privately held companies
- Private equity
- Real estate (commercial and residential)
- Vehicles (cars, boats, tractors, etc.)
Exploring Asset Liquidity: Beyond Binary Definitions
When describing their ease of selling, investments are typically divided into two categories: liquid and illiquid assets. This binary distinction is slightly misleading since “sellability” exists on a sliding scale with many assets falling somewhere in between the extremes. For example, USD is often considered the most liquid asset given its near universal acceptance as the basis of exchange. On the opposite end, real estate property is considered a classic example of a fixed asset given the complexities involved in putting a home on the market, negotiating prices, paying for intermediaries, and more. Most assets fall somewhere in between these two extremes based on a variety of factors.
What Determines an Asset’s Liquidity?
Market Size
Liquid assets tend to boast large markets that experience consistent trading volume with relative price stability. The higher the number of transactions, the more active buyers and sellers in the market. This is a hallmark of high liquidity since selling necessitates buyers. Moreover, a larger market can absorb large orders without a significant price impact, allowing investors to offload an asset at a fair market value.
Standard Pricing
Standardized pricing is crucial in assessing an asset’s liquidity. The presence of a well-established and universally recognized valuation method leads to transparent pricing for all market participants. This streamlines the trading process by virtually eliminating negotiations. It leads to a greater level of confidence among buyers and sellers who can make more informed investment decisions based on the straightforward valuation of assets.
Widespread Recognition
Assets with widespread recognition are more likely to be liquid. That’s why major currencies such as the US dollar and Euro, which are actively used in global markets, are considered the pinnacle of liquidity. This universal acknowledgment and adoption help to maintain an asset’s value while instilling confidence among investors. Furthermore, this large-scale acceptance props up consistent demand.
👉 Suggested Reading: Dollar Dominion: How the Dollar Became the World Reserve Currency
Transaction Cost and Speed
The logistics of trading an investment contribute to its classification as a liquid or illiquid asset. Investment vehicles with higher transaction costs, more regulatory requirements, and longer timelines are considered non-liquid because of the obstacles to selling. Conversely, assets that can be traded relatively quickly with little red tape and minimal transaction costs are defined as more liquid.
Keep in mind that all of these factors must be present for an asset to be considered liquid. For example, the housing market is massive and has widespread recognition. However, the sales process is protracted, and the pricing mechanisms are somewhat subjective. On the other hand, the gold market is the largest of the precious metals, it enjoys standard pricing and widespread recognition, and physical gold is relatively easy to sell.
Is Gold a Liquid Asset?
Yes, gold is a liquid asset in both its paper and physical forms. Gold might not be as liquid as cash, but it rivals stocks and ETFs in its ease of selling. As the largest precious metals market worth an impressive $5 trillion, the gold market sees persistent demand and comparative price stability. There’s a marketwide pricing standard in the form of the spot price which gives all traders an accurate idea of the value of their holdings. Even though trading physical gold comes with a small markup known as a dealer premium, this pales in comparison to the cost of selling or buying most other physical assets.
Want to learn more about diversifying your assets with gold?
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