Liquidity indicates how quickly an asset can be converted into cash. Liquidity is a desirable trait to investors, and so generally the more liquid an asset the lower the return it offers, due to investors bidding up its price.
Coins and banknotes are the most liquid assets. They do not pay interest or appreciate in value, unless they become old and of interest to collectors.
Selling antique coins will require a trip to a specialized dealer, a valuation, and a sale by auction or commission, all of which cost money. A collection of rare coins is therefore far less liquid than a holdall stuffed with dollar bills, since it is expensive to turn a coin collection into ready money.
Liquid markets
Liquidity is also used in a closely related way to describe how easily assets can be traded. The markets in which those assets are traded can be described in terms of this liquidity.
The most liquid markets have a high turnover of assets and many participants, and the cost of doing business in them is lower.
To return to the example of a coin collection, most towns will only have one or two coin dealers, who will only be able to deal in a limited volume of coins. The antique coin market is many times less liquid than the international currency markets, in which billions can change ownership at a keystroke. The market in government bonds is similarly extremely liquid.
With shares, the situation varies. Millions of shares in the leading blue chip companies are bought and sold every day – in normal circumstances this market is very liquid. The difference between the buying and selling price of the shares (known as the bid-offer spread) is tiny, as market makers in large caps can do profitable business on small margins due to the sheer volume of shares being traded.
In contrast, the shares of small companies are traded in lower volumes, with just a few thousand shares of some companies changing ownership in a typical day.
As a result, market makers charge more to cover the cost of providing a market in these small cap shares, reflected in a wider spread. An investor buying a tranche of shares in a small cap can easily see his capital eroded by 5% or more in the trip from cash to ownership of such shares because of this spread. The small cap market is far less liquid than that of large cap shares.
Prices are more volatile in less liquid markets, as a small number of participants can have a great influence on the price.
Assets can be very widely held but still not be very liquid. Residential property is not an especially liquid market: relatively few homes change hands each year, buyers and sellers must pay all kinds of fees, and it can take months for a house to change hands. When house prices fall and nobody wants or can afford to move, turnover may grind to a near-halt. At such times the market has become illiquid.
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