Liquidity generally refers to how quickly an investment can be bought or sold and converted into cash. The easier an investment is to sell, the more liquid it is. Plus, liquid investments do not charge large fees when you need to access your money.
For the average investor, liquidity is an important consideration when building a portfolio, as it’s an indicator of how easy it is to access their savings. Here’s a closer look at how liquidity works, especially when dealing with stocks.
Types of Liquidity
Liquidity comes in two forms: Market liquidity and accounting liquidity. Here’s how the two are different.
Market liquidity refers to how quickly a stock can be turned into cash. High market liquidity means there’s a high supply and demand for an asset. That, in turn, makes it easy for buyers to find sellers and vice versa. As a result, transactions can be completed quickly, even when stock values are dropping.
Accounting liquidity is related to an individual’s or company’s ability to meet their financial obligations, such as regular bills or debt payments.
For an individual, being liquid means they have enough cash or marketable assets (such as stocks) on hand to meet their obligations.
Companies measure liquidity slightly differently by comparing current assets and debt. In addition to cash and marketable assets, current assets also include inventories and accounts receivable, the money customers owe on credit for goods or services they’ve purchased.
Investors may pay attention to company liquidity if they are researching that company’s stock as a potential buy. Companies with higher liquidity may be in better shape than those in risk of defaulting on their debt.
How Liquid Are Different Assets?
An investor’s financial portfolio may be made up of a number of different assets of varying liquidities, including cash, stocks, bonds, real estate, and savings vehicles like certificates of deposit (CDs). Cash is the most liquid asset; there is nothing an investor needs to do to convert it into spendable currency.
On the other hand, an investment property is an example of a relatively illiquid asset, as it might take a long time for an investor to sell it should they need access to their money.
CDs are also relatively illiquid assets because they require investors to tie up their money for a preset period of time in exchange for higher interest rates than those available in regular savings accounts. Individuals who need their money early may have to pay hefty fines to access it.
Stocks generally fall on the relatively liquid side of the liquidity spectrum. Stocks that are easy to buy and sell and said to be highly liquid. Stocks with low liquidity may be tougher to sell, and investors may take a bigger financial hit as they seek buyers.
What Is Liquidity Risk?
Liquidity risk is the risk that an individual won’t be able to find a buyer or seller for assets they wish to trade during a given period of time, which can lead to adverse effects on the price. Liquidity risk is higher for complex investments or investment vehicles like CDs that may charge penalties to access funds early.
Are Stocks a Liquid Asset?
For the most part, stocks that are traded on a public exchange are considered liquid assets. Some stocks, like those traded on foreign exchanges, may be less liquid as it takes more time to execute a trade.
Generally speaking, when an individual wishes to execute a trade, they use a brokerage account to issue a buy or sell order. The broker then helps match the individual with other buyers and sellers hoping to take the opposite action.
This process can take a little bit of time. Most stock trades settle within a two-day period. A stock trade executed on a Wednesday would typically settle on Friday. Settlement is the official transfer of stocks from a seller’s account to the buyer’s account, and cash from the buyer to the seller.
Because it can take some time for trades to be executed, there can be a difference in price between when an individual places an order and when that order is fulfilled.
How to Calculate a Stock’s Liquidity
One way to figure out a stock’s liquidity is by looking at a metric known as share turnover. This financial ratio compares the volume of shares traded and the number of outstanding shares. A stock’s volume is the number of shares that have been bought or sold over a given period. Outstanding shares refer to all of the shares held by a company’s shareholders.
Higher share turnover indicates high liquidity; investors have an easier time buying and selling. Investors might want to pay close attention to low share turnover, as this can indicate they may have a difficult time selling shares if they need to.
Another measure of a stock’s liquidity is the bid-ask spread. Bid price is the price an individual is willing to pay at a given point in time. The ask price is the price at which a buyer is willing to sell. The bid-ask spread is the difference between the two.
For highly liquid assets, the bid-ask spread tends to be pretty small — as little as a penny. This indicates that buyers and sellers are generally in agreement over what the price of a stock should be. However, as bid-ask spread grows, it is an indication that a stock is increasingly illiquid.
A wide spread can also indicate that a trade may be much more expensive to execute. For example, there may not be enough trade volume to execute an entire order at one price. If prices are rising, an order can become increasingly pricey.
Examples of Liquid Stocks
The most liquid stocks tend to be those that receive the most interest from investors. The large companies that are tracked by the S&P 500 Index.
Why Stock Liquidity Is Important for Investors
The relative liquidity provided by stocks can be a boon to investors. Stocks help provide the growth needed for investors to meet their savings goals. They are also relatively easy to buy and sell on the market, allowing investors to access their savings quickly when they need it.
Liquidity is a measure of the ability to turn assets into cash without losing value. So it’s an important metric for investors to pay attention to as they construct their portfolios.
Liquidity is just one of many factors to consider when investing. SoFi Invest® offers investors both hands-on active stock trading accounts as well as automated accounts that build portfolios based on an individual’s goals and personal risk tolerance.
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