- Liquidity refers to the speed and the ease with which investors can realize the cash value of an investment.
- Two questions can help you get an understanding of an asset’s liquidity: (1) Can you convert the asset back to cash quickly when you want to? (2) Can you get the amount of cash you want when you do so?
- Generally, any factor that makes it harder for an asset to sell makes that asset less liquid. Some of the main factors include: trading costs or transaction fees, ease of sale, market maturity, price predictability, and information availability.
- Liquidity differs across asset classes and assets within classes. Before investing into any asset, many investors evaluate that asset’s liquidity.
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What is Liquidity?
Liquidity refers to the speed and the ease with which investors can realize the cash value of an investment.
The liquidity of an investment asset is a relationship between time and price. More specifically: how long the asset will take to sell, and the final price of the sold asset. The longer it takes to sell the asset, the less liquid it is. On the price dimension, the bigger the gap is between an asset’s final sale price and its fair market value, the less liquid that asset is.
An example of an illiquid asset is real estate. Selling a home is a much longer process than, say, selling a stock. It takes more time to sell. If you wanted to shorten the time to sell the house and realize the cash, you would likely have to significantly discount the sale price. The amount you have to discount, typically seen in the bid-ask spread, is another measure of how illiquid the house is.
Put in simplest terms, to evaluate how liquid an asset is, an investor will usually ask two questions: (1) Can I convert the asset back to cash quickly when I want to (time)? (2) Can I get the amount of cash I want when I do so (price)?
Factors that Affect Liquidity
Some of the main factors that affect liquidity include: trading costs or transaction fees, ease of sale, market maturity, price predictability, and information availability.
Generally, any factor that makes it harder for an asset to sell makes that asset less liquid. If there are a lot of fees involved in selling an asset, buyers are less likely to want to buy. If there is not a well developed market, or low trading volume, for a certain asset, then it is harder to find buyers. If market prices are very volatile, and it’s hard to predict the final price one would get from selling, then buyers might be less inclined to buy such risky assets.
Asymmetric information is a commonly studied factor involved in liquidity. Asymmetric information means that one party in a transaction might have private information or knows something about an asset that the other party doesn’t. This asymmetry can make it harder for the asset to sell.
A common example of asymmetric information is the used car market. The seller of a used car usually knows more about the car than the buyer. A buyer might be worried that the seller is just trying to get rid of a bad car or a “lemon.” They might offer less for the car than what they believe the car is worth, in case there is some secret bad thing about the car they don’t know about. The seller, in this case, wouldn’t get the fair market value of the car if they wanted to sell it, unless they’re able to convince the buyer that all the information about the car has been shared. In a market with a lot of asymmetric information and distrust, you can imagine that there is virtually zero liquidity — no one would want to buy or sell from each other at all.
Liquidity Across Asset Classes
Liquidity can vary across asset classes and also between securities within asset classes due to the factors outlined above. Assets with longer histories and more developed markets tend to be more liquid, due to there being a more robust ecosystem of supply, demand, and transparent information for these assets.
Below, we break down how investors might think about liquidity for the asset classes available to investors on Public.com.
Stocks are among the most liquid investment assets. The stock market is highly developed and mature, so investors can typically sell stocks almost instantly on many exchanges. In addition, there are many available buyers and sellers in the market. An investor can quite easily convert this asset to cash.
On the price dimension, a stock is of course, more illiquid than cash. That makes intuitive sense, but here’s how to understand exactly why: an investor may not always be able to sell the stock at the price that they believe is the fair market value. If an investor believes their stock holding is undervalued, they might have to wait some time to realize the full cash value they believe they should receive on the market.
Different stocks can also be more or less liquid relative to each other (as opposed to other asset classes). Small-cap stocks tend to be less liquid than large-cap stocks, because information about small-cap stocks is less available. Thus, awareness is lower for these stocks, and there are fewer buyers. The lack of information also means that they tend to be riskier and thus likely less attractive to prospective buyers, even if they are aware of them.
Academic financial theorists have formalized many statistics-based formulas to try to get more accurate quantitative measures of stock liquidity, such as the Pastor-Stambaugh Model and the Amihud Illiquidity measure.
Empirically, less liquid stocks have been shown to offer higher average rates of return, though the effect is diminishing. This was seen in a 1986 study by finance professors Yakov Amihud and Haim Mendleson that measured average monthly returns of stocks against their bid-ask spreads. The difference in returns between the stocks with the highest bid-ask spreads (least liquid) and stocks with the lowest bid-ask spreads (most liquid) was about 0.7% per month.
Cryptocurrencies have become more mainstream in the past decade, and thus a more liquid investment asset. Online wallets have made cryptos more accessible, and many platforms, like Public, offer investors the ability to buy and sell cryptocurrencies directly in USD.
The digital nature of crypto makes it extremely frictionless to transfer and trade the asset. Some proponents argue that this digital instantaneousness, in combination with the blockchain, makes crypto markets more transparent and decreases information asymmetry. These would all be factors that increase crypto’s liquidity. However, the transaction fees involved in transferring crypto can also be quite high, such as the gas fees associated with Ethereum. This decreases the liquidity of cryptos.
Similarly to large-cap vs small-cap stocks, well-known coins such as Bitcoin or Ethereum are more liquid than newer cryptocurrency projects, due to there being more interested buyers and sellers in the market. Lesser known coins are also less likely to be available on mainstream crypto platforms, which reduces the amount of available and interested buyers for these coins.
Pricing for crypto tends to be more volatile than other assets, affecting pricing predictability and reducing liquidity. Some have argued that asymmetric information drives this volatility. However, others argue that the blockchain makes crypto more transparent and open-source, and thus not subject to the kind of asymmetric information around “cash flows, managerial decisions, mergers, earnings” that is seen in the stock market. Stablecoins pegged to fiat currencies, or cash, have been designed to be more liquid cryptocurrencies.
Alternative assets are generally considered the least liquid assets. This is because alts are usually logistically difficult to sell. Real estate, as discussed earlier, is a good example of this.
Another example is collectibles. Selling a collectible involves many logistical considerations, such as safely packaging and shipping the collectible to the buyer. These logistics increase the time it takes to sell such an asset. Moreover, it’s also quite difficult to maintain the price of a collectible, because the asset’s value is so dependent on its physical condition. To ensure an eventual favorable sale price, a collectibles investor must also spend resources on preserving the asset’s condition, which involves more logistics, like paying for security and storage in a temperature controlled vault. Compared to other assets, there are fewer buyers on the market who desire to absorb the costs and logistics of collectibles, thus making these assets harder to sell, or less liquid.
Other more financial alternative asset classes, such as private equity or hedge funds, typically have low liquidity because these funds impose steep restrictions on their investors. These restrictions include lock up periods or redemption notices, where investors must notify fund managers weeks or months in advance in order to withdraw funds. Stock options offered by startup employers are another example of an illiquid financial asset. With these kinds of assets, investors are typically making a trade-off in liquidity for the potential of higher than average returns.
Many financial products are offered to help make alts more liquid assets. A common example is the home equity loan, where homeowners can borrow cash against the value of their home. This makes the asset more liquid because it means the investor does not need to sell the asset to realize its value in cash. It’s recently become possible to borrow against other alts, like NFTs.
Platforms like Public have increased the liquidity of cryptocurrency by allowing more investors to buy and sell cryptocurrencies without needing to go through the logistics of the blockchain (gas fees, setting up wallets, etc.). In a similar fashion, as alts become more mainstream, platforms like Public help to increase liquidity by allowing more investors to gain exposure to the asset through fractional shares without needing to worry about the logistics of buying, selling, and storing the physical assets. Shares of alts are more easily sellable, with lower transaction costs than trading the whole assets.
However, it is important to keep in mind that the liquidity of fractional alt shares themselves is still relatively low compared to assets such as stocks and crypto, as the market is quite new. As such, there are fewer buyers and sellers due to lack of awareness. In addition, there is limited information and understanding on how to value such assets, making price predictability more difficult. As awareness of fractional alts investments increases, we will likely see the liquidity of these investments increase as well.
Investors typically evaluate their liquidity needs and establish a minimum level of liquid assets they require for their portfolios. This minimum level is usually based on the amount of cash they anticipate needing in the near future. In addition, before investing into any asset, investors will evaluate that asset’s liquidity and try to estimate the timeframe in which it will take to get the investment back from that asset in cash to ensure they are comfortable with that timeframe.