What is market liquidity?
Chapter 1: Intro
Liquidity is a classic City technical term, and it’s bandied about with abandon: you’ll often hear people asking how “liquid” is a certain investment? Or how “illiquid”?
And it’s actually very simple. Market liquidity is about how quickly you can exchange, sell or re-sell an asset.
Chapter 2: Liquid vs illiquid
So, in its simplest terms, cash is very liquid – the most liquid investment you can have. In contrast, a stolen painting is very illiquid. Anyone prepared to pay serious money for a stolen Turner or Picasso knows it will be difficult to sell on.
Unsurprisingly, property is (mostly) illiquid. Bricks and mortar can’t be exchanged quickly because a property sale demands that owner and seller organise surveys and other due diligence legal processes. And that can be quite a hassle.
Other highly illiquid assets include:
• Classic cars
• Race horses
• Vintage wine (ahem)
• Complex financial instruments, such as derivatives
• Shares that may have complex overseas business
By contrast, you’re much more likely to sell popular stocks or shares, such as Unilever or Apple, straightforwardly and quickly.
Chapter 3: How liquid are gold and silver?
In theory these commodities should be very easy to sell. However the sale spreads – the profit made by the agent handling the transaction – are often wider (or bigger). Not many investors own large amounts of physical gold or silver.
So unless you’re one of those lucky people, the sale cost, without economies of scale, tends to be higher. At least compared to selling shares, for example.
And be aware that when the value of world stock markets rises, commodities like gold and silver often fall in response. So gold and silver then become even more illiquid.
Chapter 4: How much does liquidity matter in investing?
Liquidity is hugely important. Let’s briefly look at financial liquidity in investments or shares:
‘Good’ liquidity is often about high trading volumes and narrow spreads (or sales cost). For example, let’s examine a ‘defensive’ or ‘safe’ stock. For the sake of argument we’ll call it National Solid Flooring (NSF), a fictitious UK-based company that has grown steadily since 1950. Let’s say shares in NSF sell for £10 apiece.
Typically it might have a Bid-Ask price of £10 and a Bid-Offer price of £9.97. The bid-offer spread here being 3p or just 0.29% overall.
Another stock might be much less liquid. Let’s call it National Less Liquid Supplies (NLLS) which might have a heavy trading arm in Asia and therefore prone to volatile currency fluctuations. It has traded since 2003.
NLLS might have a Bid-Ask share price of £1 and a Bid-Offer price of 97p. The bid-offer spread has widened to 3p too – but in total percentage terms it’s a far bigger drop: three percent in fact.
And remember, that 3% cost may also be inflated by other broker commissions on top – which you, as the investor, will also pay. In other words, liquidity matters… a lot!
Box-out: Horses for courses
Don’t be scared off all illiquid stocks. Yes, they can be expensive to trade. But if you’ve done your homework, they can be excellent value longer term. Especially if they’ve fallen out of favour with the market and are selling at a good discount.