Whilst it’s unlikely your financial goals are identical to your friends and colleagues, you’ll all have one thing in common; at some point, you will need to turn your investments into cash to achieve those goals.
When it comes to your investments, it’s important you know how easily and quickly you can do this, without having a negative impact on the overall value of your investment. This is called liquidity.
An asset is described as ‘liquid’ when it’s easy to trade – a share in a FTSE 100 company can usually be bought and sold within seconds on the stock market, for example.
When an asset is more difficult to buy and sell, or if you need to lower the price to offload it quickly, an investment is considered ‘illiquid’. Property is a typical example of an illiquid asset – it takes longer to sell, and the process can be complicated.
Liquidity and the economy
Liquidity is crucial for a healthy economy. When you want to understand a company’s finances, for example, the balance sheet doesn’t always reveal the full story.
Imagine a fashion retailer; it owns the buildings it works in, the equipment it uses, and lots of stock that it’s waiting to sell. These are all worth something, but they can’t be turned into cash immediately. The company might have a lot of assets, but does it have enough cash to pay its bills and the wages of its employees?
Now imagine this scenario in the banking sector, which has a lot of cash flow. When the 2008 financial crisis hit, many banks faced a liquidity crisis. Much like the example of the clothing company above, they had assets, but most were tied up in long-term loans, such as mortgages.
As the money markets – highly liquid assets with short-term maturities – slowed down during the crisis, the banks struggled getting their hands on enough cash. They couldn’t just ask regular homeowners to repay £100,000 or so of their mortgage because they needed their money back.
This is where governments can sometimes step in to try and inject confidence in the system and prevent everyone from withdrawing all their money, by providing short-term liquidity.
Why is liquidity important for investors?
Liquidity is also crucial for the average investor, as different goals require different levels of flexibility. If you’re investing for a rainy day, you need to know you can access your money quickly in an emergency. If you’re buying a home or investing for your retirement, you’ll be more willing to lock your money away for a bit longer.
This doesn’t mean you should only invest in assets that are easy to sell, because that could potentially restrict your returns. Cash is seen as a liquid asset, but investors sacrifice potential returns for this perceived safety. Against a backdrop of rising inflation, cash can lose value over time.
Investors looking to benefit from a liquidity sweet spot may look to exchange traded funds. Traded on an exchange, these funds track specific markets and can give investors low-cost and liquid exposure to assets that are typically more difficult to trade, like property and debt instruments. It can also give you the scope to quickly adjust what you’re invested in to match changing market conditions and take advantage of any opportunities should they arise.
Essentially, liquidity gives you the control to manage your future, in the way you want.