Understanding risk, Part. 2: Liquidity

Posted by TEBI on August 24, 2022

Understanding risk, Part. 2: Liquidity





Many investors underestimate how important liquidity is, and the risks they face when it isn’t there. 


How do you know the price of any asset? For the big shares on the stock market it is easy. Hundreds of thousands of shares in Apple or Amazon are bought and sold every day, and the price is agreed every time a trade is made.

The price of fine art is harder to determine. Earlier this year, for example, an abstract painting by Lucy Bull sold for $1.5 million at Sotheby’s. That was more than seven times higher than its high estimate price of $192 000.

In other words, what Sotheby’s thought the painting could sell for, proved to be completely wrong. No one, however, makes that mistake on a daily basis when trading shares in Apple.

This illustrates why liquidity is so important. It might sound like a technical term that most investors don’t need to worry about, but actually it is a risk that is likely to affect everyone at some point.


Finding a buyer

Essentially, liquidity refers to how quickly something can be sold. Shares in Apple or Amazon are highly liquid because they trade in huge volumes every day on the stock market.

Paintings by Lucy Bull are a lot less liquid. There are far less of them, for one thing, but there also aren’t huge numbers of people looking to pick one up every day. Only a few people have a few million to spend on fine art, and so anyone who has an expensive painting and wants to sell it will take a bit of time to find a buyer.

This is important for investors for two reasons. 

Firstly, if something can’t be traded quickly in a large market, it is difficult to determine what its price should be. Secondly, and perhaps more significantly, if an asset can’t be disposed of quickly, it is difficult to minimise any potential losses.

Even if Apple’s share price falls, it won’t be too difficult to find a buyer. You can therefore manage a potential loss if you want to get out. But if you own a Lucy Bull and the art market loses interest in her work, disposing of your painting at anything like what you paid for it could be almost impossible.


Small caps and large properties

This is liquidity risk — the fact that if you are caught in an illiquid investment you may have to take a big loss if you want to get rid of it.

On the stock market, small cap stocks are often talked about as being riskier than larger stocks, mostly because they are less liquid. Apple shares trade in the thousands every minute, but some shares on the Aim exchange may not trade for weeks or even months at a time. 

This means that if you own these shares and need to sell them in a hurry for any reason, you will struggle to get a good price for them. And since any asset is only worth what you can sell it for, you might find that these shares are worth a lot less than you expected.

This also happens in the housing market. A property may be valued at £1 million today, but if there is a severe downturn and you need to sell it, you will probably not realise that much.


No value at all

Where liquidity risk can really become a problem, though, is when it is taken one step further. Because if an asset is only worth what you can sell it for, that means that if you can’t sell it at all, then it is worth nothing.

Many people putting money into ‘alternative’, unregulated investment schemes miss how important this is. 

Mutual funds or ETFs have guaranteed liquidity. Whenever you want to buy or sell, you will also be able to do so. But this isn’t the case with many other so-called investment opportunities. 

Collectible coins, for example, are a fad that seems to come and go. Dealers sell them on the promise that their price will go up, but they make no guarantees about buying them back. And if you can’t find a buyer for the coin that you paid thousands of pounds for, then what is it actually worth?

There have also been examples of firms selling ‘baskets’ of rare metals. These are even priced regularly, with the price inevitably going up. How they got to these prices is a bit of a mystery, however, because when investors wanted to sell, there was never any market for them.


Out of the ordinary

In this case, investors were left holding assets which were, effectively, worthless. Since no one would buy them, they have no value.

This is one of the reasons why it is so important to think very hard about ‘investment opportunities’ that are out of the ordinary. If they involve buying an asset in the belief that its value will increase over time, always remember that in order to realise that value, there needs to be a buyer at the other end.

And if there isn’t a real market for it, and buyers aren’t that easy to find, liquidity risk may well take its toll.


One of South Africa’s most respected financial journalists, PATRICK CAIRNS is a trusted commentator on the world of investments and the quirks of behavioural finance. Over more than a decade he has built a reputation for keeping the industry honest, and putting the interests of investors first.

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