As a new investor, you might come across a concept known as liquidity risk. Liquidity risk is the hazard that an investment you get into may lack a ready market of either buyers or sellers.
It is an important thing you should understand about liquidity risk and why it impacts your financial well-being.
Liquidity refers to an asset that has a ready and waiting market on both sides of the buy-sell equation. On the other hand, liquidity risk can attack you in other, unexpected ways.
Liquidity Risk: The Short Version
Liquidity risk refers to the risk that an investment won’t have an active buyer or seller when you are ready to make a transaction. If you are selling, this means you will be stuck holding the investment at a time when you need cash.
In extreme cases, liquidity risk can cause you to take huge losses. In addition, you have to mark down your property at fire-sale prices to attract buyers.
Investors often demand a higher rate of return on money invested in illiquid assets. The aim is to compensate for liquidity risks. It means that a small small business can’t be easily sold in most cases so investors are likely to demand a higher rate of return for investing in shares of it than they would a highly liquid blue-chip stock. Likewise, investors require a much smaller return for parking money in the bank.
Historical Cases
One of the reasons for losses suffered by financial firms was the fact that these companies owned illiquid securities. It happened during the Great Recession.
When they found themselves without enough cash to pay the day-to-day bills and wanted to sell these assets, they discovered that the market had dried up completely. As a result, they had to sell at any price they could get.
For instance, the case of Lehman Brothers. They financed too much short-term money and the management was not well-prepared. They used short-term money for buying long-term investments that weren’t liquid.
That was a mistake, so when the short-term money was withdrawn, the firm couldn’t come up with cash. Hence, they couldn’t sell the long-term.
On the upside, there is an opportunity with liquidity risk because other companies and investors that were flush with cash were able to buy distressed assets.
Some of these “vulture” investors made a killing because they had balance sheets that could support holding non-liquid investments for long periods of time.
Risk of Widening Bid-Offer Spreads
When an emergency hits the market or an individual investment, you may see the bid and ask spread blow apart. As this gap widens the market maker may have a difficult time matching up buyers and sellers.
Take an example, your share of company XYZ stock may have a current market price of $20 but the bid may have fallen to $14 on an expected bad earnings report. Hence, you can’t actually get the $20 as the most someone is willing to pay is $14.