What is Liquidity: Meaning and Strategies in Investing

There are several core principles every investor should understand – and one of the most important is liquidity. Alongside strategy, diversification, hedging, and asset selection, liquidity plays a critical role in determining how well your investments perform under pressure.

But what exactly is liquidity? And why should it matter to you as an investor? Let’s break it down.

What is Liquidity?

In simple terms:

Liquidity is the ability to convert an asset into cash quickly and easily.

Liquidity measures how quickly and efficiently you can turn something you own – like a stock, bond, or commodity – into spendable cash. This matters most during volatile market conditions or in times of financial need.

The most liquid asset is cash itself. It’s available immediately and can be used to buy other assets on demand (subject to market or broker limitations).

On the other end of the spectrum, illiquid assets include real estate or collectibles like rare art or vintage cars, which can take months – or even years – to sell.

Two Main Types of Liquidity

Liquidity comes in two forms: market and financial (or accounting) liquidity .

1. Market

Market liquidity refers to how easily assets can be bought or sold in a particular market without significantly affecting the asset’s price.

Highly liquid markets, such as the stock market, have a large volume of buyers and sellers. For instance, the global stock market is worth over $124 trillion, and modern trading platforms make it incredibly easy to buy and sell shares.

Even if a company’s performance fluctuates, you can usually sell shares quickly – though the price might vary.

In contrast, a niche market like rare books is far less liquid. Finding a buyer can take months, and prices are often unpredictable due to limited demand.

Market liquidity is shaped by investor demand and the amount of cash circulating in the system.

2. Financial (Accounting)

Financial liquidity refers to your ability to cover short-term obligations using assets you can quickly convert into cash.

Let’s say you want to invest €10,000 in the S&P 500 but don’t have the savings, so you take out a loan with 7% annual interest. If the market returns 8.5% annually, your investment might yield a profit – but only if you can sell quickly when needed to make your loan payments.

Now imagine instead you spent €10,000 on a rare painting. You still owe the bank interest, but selling the painting could take months. If the value doesn’t rise enough (or at all), you’ll lose money – or worse, be unable to repay the loan on time.

To assess liquidity, companies often use the current ratio:

Current Ratio = Current Assets / Current Liabilities

A ratio above 1 means you can cover short-term liabilities with your existing assets.

Why Liquidity Is Crucial for Investors

Liquidity isn’t just a side note in your investment plan – it’s a key consideration that directly affects your ability to respond to market changes, emergencies, and new opportunities.

1. Maximise Profit or Minimise Loss

Timing is everything. If you own a rising asset, you’ll want to sell quickly to lock in profits. If prices are falling, you’ll want to exit before losses deepen. Only liquid assets allow you to act fast.

2. Quick Access to Cash

Unexpected expenses can pop up at any time. If your savings fall short, selling assets helps cover costs. Illiquid assets, like property, are of little help in a financial emergency.

3. Seize New Investment Opportunities

Markets don’t wait. When a new opportunity arises, being able to free up capital quickly is key. Liquidating part of your portfolio shouldn’t be a lengthy or costly process.

4. Lower Transaction Costs

The more liquid an asset is, the more participants it attracts – and the lower the transaction costs. For example:

• Selling €100,000 worth of shares might cost under 1%.
• Selling a property in Bulgaria could cost 5.7% to 11.5% of the sales price.

Examples of Assets by Liquidity

Here’s a list of common assets ranked from most to least liquid, based on data from the Institute of Corporate Finance (with slight adjustments):

1. Cash
2. Foreign currencies
3. Cryptocurrencies (24/7 markets)
4. Guaranteed investment certificates
5. Government bonds
6. Corporate bonds
7. Stocks
8. Physical commodities (gold, silver, platinum, etc.)
9. Real estate
10. Collectibles (art, rare wine, vintage cars, jewellery, etc.)

This list is a helpful reference when building a portfolio based on liquidity preferences.

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Managing Liquidity in Your Portfolio

An ideal investment portfolio includes a mix of three broad asset classes: stocks, bonds, and alternative investments . Each has its own level of liquidity.

According to a 2024 Bank of America survey, high-net-worth investors typically keep 15 – 19% of their portfolios in cash. The reasons?

• To jump on opportunities quickly
• To buffer against losses in less liquid parts of the portfolio

While holding that much cash may not suit everyone, it’s generally wise to keep at least 5% in liquid form to stay financially agile in the short term and longer term.

Final Thoughts

Liquidity is the ease with which assets can be turned into cash – and it’s just as vital to successful investing as diversification, timing, or discipline.

The most liquid assets – like cash or publicly traded stocks – give investors flexibility, lower transaction costs, and a way to respond to the unexpected. Illiquid assets can still have a place in a portfolio, but they come with limitations.

Understanding and managing liquidity ensures that when opportunity knocks – or challenges arise – you’re ready.