Article
A popular saying in the world of finance is that liquidity, or the ability to sell something, exists until you need it. Understanding the liquidity of the investments you own and how liquid your balance sheet is can be the difference between joy and despair.
For a brief moment let’s pretend that the only way to buy something is with dollar bills. In this fictitious world imagine that you have two investments dollar bills and a house. One day you head to the grocery store and all your dollar bills are gone. Now what? Can you sell your house? What is the correct price for your house? How long will it take to sell your house? If you price your house to low it sells quickly and you left money on the table. If you price your house to high it takes a long time to sell. To make matters worse while your house is on the market and you are trying to make a very important decision you are starving. This is an extreme version of liquidity but if you own art, a limited partnership, real estate, a private business, an exchange traded fund (ETF), a stock, or a bond you need to know:
• How liquidity impacts each of these investments.
• How you can use liquidity to meet your current cash flow needs while maximizing your long term return.
Creating an exact estimate for liquidity is impossible. In the stock and bond market the bid/ask spread is a current measure of liquidity for stocks, bonds, and ETFs. The bid is the price that someone is willing to pay for your investment. The ask is the price that someone is willing to sell you an investment. The difference between the bid and the ask is a measure of liquidity.
If a stock or ETF is not traded often the bid/ask spread will be large meaning that you will sell the stock for less than you think, buy the stock for more than you think. In addition to selling for less and buying for more a large bid/ask spread can create rapid price changes. The problem with bid/ask spreads is that they are also dependent on the market mood. When anxiety plagues the market bid/ask spreads swing wildly and your liquid ETFs can become dangerous to your financial health. While bid/ask spreads can and do change based on moods certain classes of stocks have more liquidity than others. Small company stocks typically have lower liquidity than large company stocks. When times are good small company stocks can still pose liquidity challenges, but when times turn bad and even large company stocks see liquidity drying up small company stocks and thinly traded ETFs can become as liquid as a ten year old car. There are numerous trading strategies that you can use to help manage price and speed, but knowing the investment’s liquidity before you buy and how the investment changes your balance sheet’s liquidity profile is the best trading strategy.
The speed at which you can get out of a decision measured against the emotional pain experienced during the process is what liquidity is all about. The attributes of liquidity are time, size, and popularity. All of these factors are dynamic resulting in the need to view liquidity on a continuum with assets being at different locations at different points in time. To maximize the growth of your balance sheet and minimize your emotional stress pay attention to liquidity at both the investment level and the balance sheet level and make sure that your balance sheet can provide for your essential spending needs in a variety of market environments.
