As a new investor, you might come across a concept known as liquidity risk. It 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. For the previous article, click here.
Being cash-poor is another type of liquidity. This is the inability to meet cash obligations when a payment is due. It is the investment equivalent of defaulting on a debt.
If a company has $100 million in bonds that reach maturity, it is expected to pay off the entire $100 million balance by the maturity date. Otherwise, if the company couldn’t come up with the whole $100 million, so it could be hauled into bankruptcy even it is highly profitable.
Inability to Raise Funds
If a company is unable to raise funding at a price they can afford, so it will go to the liquidity risk. This happens when a company or other investments are impossible to raise enough money to function properly.
The example is Wal-Mart Stores, Inc. It was one of the biggest and most profitable companies on the planet. The profit was up to tens of billions of dollars in debt. Suddenly, the markets changed. Wal-Mart could no longer borrow at 6% and its cost of raising funds would increase drastically.
The market’s liquidity would have dried up completely and the Wal-Mart stockholders’ would have to worry about the company coming up with enough cash to wipe out all of its debt.
How to Protect Yourself from Liquidity Risk
To protect your profit from liquidity risk, you have to highlight these tips. First, unless you can afford to hold them through terrible recessions and job loss, never buy illiquid long-term investments.
Second, make sure that the bigger the cushion between the cash you earn each month, the less the chance you get caught in a liquidity risk crisis.
Last but not least, avoid investing in companies that are facing potential liquidity risks. You can read the review to deposit your money, so make sure that all have a good track record.