Liquidity: How It Affects Investments

Liquidity: How it Affects Investments

There are several factors that influence what assets are the best to invest in. People often choose investments that give a high expected rate of return, while others choose ones for other reasons. Investors demand for various assets are based on three main characteristics. The first is the expected return the asset provides compared with the returns provided by other assets. The second characteristic is the risk associated with the asset's expected return. The third characteristic, which this paper discusses, is the liquidity of the asset. Liquidity is a unique characteristic that describes how easy and at what cost an asset is able to be sold. It is important when investing to understand that there is inherent risk with holding assets that are more liquid, but there are also potential greater rates of return with less liquid investments. This paper will analyze liquidity in relation to various types of investments on multiple scales.

Money and Liquidity

Money is often referred to as the most liquid of assets, because it is a medium of exchange, a unit of account, a store of value, and is generally accepted for the payment of debt. A medium of exchange is an important concept with money because it eliminates having to determine the price of one good in terms of others, and all goods and services can be valued with a common unit. The other characteristics of money recognize its value in purchasing assets or lending funds. From an international point of view, money is translated into several currencies, from the dollar in the U.S., to the euro in Europe, and the foreign exchange market determines the value of one currency in terms of another. Investors sometimes choose to hold their assets in the form of money because it is the most liquid asset and does not need to be converted to another form before people are willing to accept it. However, they can expect much lower rates of return if they keep their money in savings or checking accounts. Although keeping finances in the form of money eliminates the problem of converting assets into money, an inherent risk with keeping assets tied in fiat money is that in periods of inflation, the assets could depreciate. This illustration could be seen with the hyperinflation Germany experienced in the 1920s, where the currency had no value and was often burned as a replacement for firewood.

Less Liquid Investments

Other investments that are relatively liquid are certificated of deposits, savings bonds, stocks, bonds, and futures. These investments are usually easily sold and converted to money, although they can sometimes be associated with a slight penalty for conversion before maturity. Investors who are more risk seeking will purchase these assets because they know they offer higher rates of return and they are still relatively liquid. Investors that hold certificates of deposits (CDs), for example, hold little risk other than if they need cash and they have to exchange their CD and receive a penalty. Another example is the stock market, which is considered very liquid, especially the large-scale companies and indexes such as the S&P 500. A stock is said to be relatively liquid if the shares can be rapidly sold and selling has little effect on the stock's price. The stock market is so large that if an investor wants to sell their stock, there usually is willing buyers at the same time. One way to measure the liquidity of stocks is to look at the bid/ask spread, which is the difference between the bidding and asking prices for a stock. A small spread indicates high liquidity for a particular stock.

Investments that are even less liquid than the aforementioned assets include collectibles, such as coins or art, and the least liquid asset, real estate. These forms of investments can have high rates of return, but may not easily be sold, as a buyer must have an interest in purchasing the asset for the holder to convert it into money. Real estate, for example, is a very popular asset, but if an investor has a large percentage of their portfolio tied into real estate and they need cash to pay back their financial obligations, they could be in substantial trouble if no buyers are interested. One way that investors guard against the risks of illiquid assets is to back them up with money market assets and cash. Banks, for example, are required to have a minimum cash supply at all times. CDs, treasury bills, and bonds are all forms of short term assets that can be quickly converted to cash.

Foreign Exchange Market

A form of investment that