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Why does liquidity matter?

Wondering what liquidity is and how it impacts your investment decisions? This article will explain liquidity and its importance when making investment decisions.

The world of extreme sports is both exciting and dangerous. The human body is pushed to the outer limits where the risks are high, and failure is not an option. Risk management is at the core, where extensive training, muscle memory, and the fastidious assessment and identification of all risks are made. These are then mitigated or removed totally. In so many ways, extreme sports are like investing, and none more so than in a subcategory of extreme diving – freediving.

Freedivers dive to the lowest depths possible without the aid of traditional scuba breathing apparatus and only cling to a rope as they plunge into the deeper depths of the unknown. They swim to depths with crushing atmospheric pressures in pursuit of records, and in August 2022 Poland’s Mateusz Malina set a new world record in the free immersion discipline when he dived to 127m a depth of 417 ft. What is exceptional about the record and the many who have attempted the same feat is that the divers hold their breath for just over 4 and a half minutes underwater without taking any fresh air in when all around them is crushing water pressure.

Just think of the last time you were in a swimming pool and tried to swim the length of the pool underwater. You might be underwater for 30 seconds or so before a mild panic attack ensues. All swimmers need oxygen, whether freedivers or recreational swimmers. In the same way, investment markets need their own oxygen – liquidity.

An investor’s view of liquidity

At its very basic level, liquidity refers to the ease by which you can sell any asset and convert it into cash. Different assets and asset classes of investments have very different timescales to convert to cash. For example, a major publicly traded stock has very high levels of liquidity – where there is a ready market to buy and sell the stocks almost immediately.

For example, you can easily trade in and out of Amazon shares (NASDAQ: AMZN) because there are plenty of buyers and plenty of sellers. You just need to look at the order books on any given trading day to see how the buyers and sellers at any given time match up and how easy it is to buy and sell. The same cannot be seen for real estate assets.

The sales and legal process for real estate can be long. By the time real estate agents have shown people around the property, offers have been made, and buyers have carried out their own due diligence supported by their banks providing a mortgage, together with all the legal paperwork to confirm the transference of legal ownership the clock has been ticking on average in the US for around 72 days (according to ice mortgage technology reports. If you need access to funds immediately you will probably have to offer a healthy discount to get a quick buyer – typically by taking the property to auction.

Serious Investors will allocate their investment to different types of assets that have different liquidity profiles. This means in an emergency they have assets they can sell quickly, rather than having to offer an illiquidity discount for a quick sale of an asset with less liquidity.

Illiquidity discounts and premiums

For an asset that takes time to sell or for which there is a limited marketplace illiquidity discounts need to be offered to sell quickly. Equally, if a market is very thin and there is a massive demand for the same asset there could equally be an illiquidity premium associated with needing to buy a unique asset quickly. You often see this where people may be outbidding each other on a very special piece of real estate, or a rare Van Gogh painting that has come up for auction.

Professional traders and liquidity

For professional traders, liquidity is a non-negotiable tool for risk management. Professional traders use liquidity to help their risk management. Traders love to trade volatility. One of the key elements of their risk management strategies, however, is to set put stop losses in place if a trade goes against them and the price of the asset unexpectedly falls.

Stop losses are the point at which a trader recognizes their trade is a losing trade. Professional traders plan their trade and trade their plan and within the planned trade is a stop loss designed to automatically sell the asset and take a small loss but preserve the bulk of their core capital. These are essential strategies for the cryptocurrency markets, which trade 24/7  where marked volatility can occur – often driven by bad news. If bad news releases when you are asleep you need automated processes that provide you with risk management. With plenty of buyers and sellers on major exchanges, Bitcoin provides the liquidity to automatically trigger a stop loss and get you out of a losing trade. If the market was very illiquid you may not be able to sell your asset automatically for the price you wanted and may incur very heavy losses.

In summary, therefore, we can see how liquidity is a powerful tool to give you flexibility as an investor with a portfolio balanced with asset classes with different liquidities that perhaps enjoy recreational swimming,  and as a fundamental risk management tool for traders that thrives on high-risk volatility but plans the downside very carefully like the freediver. Which type of swimmer are you?

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