By Rebecca Lake
Investing is naturally a risky proposition, and there are specific types of risk to be aware of when deciding where to put your money. Liquidity risk is one of them. Broadly speaking, it refers to how easily an asset can be converted to cash and sold. Understanding this type of risk is important because it can directly affect how easily you’re able to move securities in and out of your portfolio. For guidance in evaluating the liquidity risk of a particular investment or the liquidity profile of your overall portfolio, consider enlisting the help of a trusted financial advisor.
Liquidity Risk, Definition
Liquidity risk can have different meanings, depending on how it’s used. From an investment perspective, liquidity risk relates directly to how easy it is to buy or sell assets. The more liquid an asset is, the easier it is to convert it to cash and find ready buyers. Assets that are illiquid take more time to convert to cash and sell.
Examples of highly liquid assets include:
Assets that tend to be more illiquid include:
The term “liquidity risk” can also be used to describe a company’s ability to meet its short-term financial obligations. A company that has assets it can easily sell or cash reserves that it can draw from to pay its bills generally has a low liquidity risk. On the other hand, a company that may be forced to sell assets at a low price to cover day-to-day cash flow needs or debts has a higher liquidity risk.What Liquidity Risk Means for Your Portfolio
Understanding liquidity risk is central to managing your portfolio’s overall risk profile. Knowing how liquid your assets are can help you devise an investment strategy that reflects your goals and risk tolerance while potentially insulating you against losses. For example, say you want to diversify your portfolio with some real estate holdings. You have several options for doing that, including buying a rental property, investing in crowdfunded real estate or buying shares in a real estate mutual fund or ETF. All three can offer exposure to real estate but they can also have different liquidity risk and return profiles.
Crowdfunded real estate, for example, tends to be more illiquid, since investments may have a required holding period of five years or longer. A real estate mutual fund or ETF, on the other hand, tends to be more liquid and can be sold relatively quickly.
Liquidity risk can be crucial when you need to sell assets and convert them to cash. If you have an investment you want to sell but there are no buyers, you may be stuck holding onto it for longer than you’d like. Or you might find yourself in a worst-case scenario where you have to sell an investment at a loss just to unload it and get the cash. This kind of situation can happen if you own a home or another piece of real estate that you’re trying to sell in a down market.
Either one could be bad for your portfolio if your asset allocation ends up skewed or you have to take a loss to get out of an investment. There are some positive trade-offs, however, for adding more illiquid investments to your portfolio. Sometimes, the harder it is to sell an investment, the higher rate of return it may produce. Crowdfunded real estate and rental properties, for example, could generate better returns over time compared to a real estate ETF.
On the other hand, lower liquidity risk can sometimes translate to a lower rate of return. Take certificates of deposit accounts and money market accounts, for instance. The money you keep in these accounts is going to be much more accessible than the money you invest in stocks or mutual funds but they also offer much lower rates of return.Managing Liquidity Risk When Investing
Understanding liquidity risk can help with managing it inside your portfolio. For example, knowing how to measure a company’s liquidity using the current ratio can help you decide whether it’s a good investment.
The current ratio is calculated by dividing a company’s current assets by its current liabilities. A higher ratio means the company likely has sufficient assets and liquidity to meet its obligations. A current ratio of less than one could signal financial instability. Even if a company looks good on paper in terms of its revenues and profitability, it may not necessarily be a good investment if it lacks cash reserves or it’s invested too much of its own money in illiquid assets.
Liquidity risk can also be used as a guideline for choosing investments based on the time horizon involved to hold them. Again, something like a REIT or rental property is typically a longer-term investment with a holding period extending over several years. A fix-and-flip property, stocks or mutual funds, on the other hand, may have holding periods that only last a few months – or less – instead.
Knowing what part of your portfolio you’d like to keep in cash can help with deciding how and where to allocate your investment dollars. For example, you might decide to keep 5% to 10% of your assets in cash or cash equivalents so that if a financial crisis comes along, you’ll have some liquid funds on hand.
Finally, liquidity risk can be a useful tool when looking for bargains in the market. If you have substantial cash reserves, for instance, you could use them to buy distressed or other illiquid assets at a discount if an investor is selling them because they’re desperate for cash themselves.The Bottom Line
Liquidity risk can directly affect investment outcomes so it’s helpful to know how to manage it. You can also use it as a guide for deciding where to invest so that your portfolio stays properly diversified while potentially taking advantage of buying opportunities in the market.Tips for Investing
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