- Liquidity refers to the ability to convert a security to cash
- Assets have varying levels of liquidity
- Markets can also be liquid
Ever hear someone talk about how something can be “liquid”, even though it has nothing to do with water?
You’re not mistaken–it’s yet another term in an ocean of monetary shoptalk that leaves you feeling like you’re in way over your head.
Thankfully, “liquidity” is relatively easy to understand. There are no fancy formulas or abstract instruments to memorize.
Instead, liquidity simply has to do with the ability to buy or sell your investments.
Liquidity refers to the speed and ability to buy or sell a financial asset or to convert it into cash. The more “liquid” an asset, the faster it can be sold for cash, without affecting its price.
If it’s easier to tie the idea of liquidity to actual liquid, you can try to think of an investment, or asset, as an ice cube. If you own an ice cube, then liquidity as the amount of time and effort it takes to melt that ice cube into water.
So, for an investment—like a stock or bond—its liquidity is a measurement of how long it takes you to sell it for cash.
Assets that can be converted quickly into cash are said to be easily liquidated. They’re also commonly called liquid assets, meaning that, again, they can quickly be converted cash.
In fact, cash itself is considered a liquid asset, as is the money you have sitting in a savings account. The idea is that the asset can rapidly be converted and accessed in case of an emergency, or even if you wanted to seize a market opportunity.
For example, if your car breaks down and you need cash to pay for repairs, cash can be withdrawn from your savings account at an ATM, making your savings account, in effect, liquid.
Markets can also be described as liquid.
In a liquid market, assets are relatively easy to sell. Conversely, in an illiquid market, bid-ask spreads are larger, and selling an asset requires more work. It’s more difficult, in other words, to convert an asset into cash.
Good to know: Often you’ll hear about something called the bid-ask spread –which is the difference between the highest price a buyer is willing to pay for an asset, and the lowest price for which it will sell. The bid-ask spread is small in liquid markets, and high in illiquid markets.
That’s because, in a liquid market, it can be easier to buy and sell assets due to a higher volume of buyers and sellers. More potential buyers translate to the higher level of liquidity for your assets.