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What is liquidity?

Liquidity indicates how quickly an asset [1] can be converted into cash. Liquidity is a desirable trait in an investment.

In general, the more liquid an asset, the lower the return it offers. Investors bid up its price because they value owning assets that can be quickly converted into cash [2].

Coins and banknotes are the most liquid assets. They do not pay interest and in normal times they do not appreciate in value, unless they become old and of interest to collectors.1 [3]

Selling antique coins will require a trip to a specialized dealer, a valuation, and a sale by auction or commission, all of which take time and cost money, and so reduce liquidity.

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

The term liquidity is also used 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, even big towns will usually only have one or two coin dealers. Those dealers will only be able to trade in a limited volume of coins.

Thus 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 [4] 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. This means the difference between the buying and selling price of the shares (known as the bid-offer spread [5]) is usually 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 typically traded in lower volumes. In some instances, just a few thousand shares might change ownership in a typical day. Perhaps on some days no shares are traded at all.

As a result, market makers need to charge more to cover the cost of providing a market in these small cap shares. This is reflected in a wider spread.

An investor buying a tranche of shares in a particularly illiquid small cap can easily see their capital eroded by 5% or more in switching from cash to such shares because of this spread. The small cap market is far less liquid than that of large cap shares.

Prices are usually more volatile in less liquid markets, as a small number of participants can have a great influence on the price.

Academic research has pointed to an illiquidity premium for shares. This relationship suggests [6] that owners of less liquid shares will earn a higher return than more liquid ones, as investors demand a higher return for not being able to use their rarely-traded small cap shares as a costless ATM.

A six month trade with a £5,000 spread

Assets can be very widely held but still not be very liquid.

Most people in the UK own their home, but residential property [7] 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.

Master more financial terms with the Monevator glossary [8].

  1. In deflationary times, cash does increase in value in real terms, because prices are falling and so your cash buys you more each year. [ [11]]