Which Investment Has the Least Liquidity?

Not all that glitters can be easily sold, especially when it comes to your investments.

Some can be cashed out in a blink, while others take longer. But how do you strike the perfect balance between liquid vs. non-liquid assets to create a diversified portfolio that offers long-term growth and short-term flexibility?

Below, we’ll explore what makes an asset liquid or not, uncover the hidden gems of illiquid investments, and discover strategies to balance your portfolio for both quick access and long-term growth.

What Is Liquidity?

Liquidity refers to how quickly and easily an asset can be converted into cash without affecting its market price. If your investments are mostly liquid, you can quickly sell them for cash if you need money for an emergency or want to take advantage of a new investment opportunity.

However, if your investments are mostly illiquid, converting your assets into usable funds will take longer. You might have to wait for the right buyer or even sell at a lower price if you’re in a rush.

Having a mix of liquid and illiquid assets in your investment portfolio offers the potential for high returns and the flexibility to respond to changes in your financial needs or market conditions. Liquid assets can provide you with quick access to cash, while illiquid assets often have the potential for higher returns over time. Balancing the two can help you achieve your financial goals while keeping a safety net for unexpected expenses.

What Investments Are Considered Liquid Assets?

Turning your investments into cash isn’t always as quick as snapping your fingers, but some assets come close. From the savings in your bank account to the shares in your brokerage account, each asset has its own path to becoming spendable money.

Let’s look at some investments that measure up in terms of liquidity potential:

• Cash is already in its most liquid form and requires no conversion, making it immediately available for use.
• Savings Accounts and Money Market Funds allow direct withdrawals via electronic transfers, ATM withdrawals, or checks. Transactions are often instant, but some transfers may take up to one business day for the funds to become available.
• Stocks on Major Exchanges can be sold through your brokerage account. After placing a sell order, the transaction is usually executed during trading hours, and the proceeds are generally available within two to three days, depending on the brokerage’s settlement period.
• Government Bonds can be sold through a brokerage. The timeline for converting these bonds into cash and the availability of funds will depend on the bond’s market demand and the brokerage’s settlement period, which is typically within two to three days.
• Treasury Bills are short-term securities that are redeemed for cash at maturity. The process is automatic, and the funds are usually available the next business day. Alternatively, selling them in the secondary market through a broker before maturity will typically make funds available within two to three days, following the brokerage’s settlement rules.
• Exchange-Traded Funds (ETFs) are traded like stocks, meaning you can sell them through your brokerage during trading hours. The settlement period is similar to that of stocks, with funds usually available within two to three days.
• Mutual Fund shares can be redeemed by requesting a sale through your fund management company or broker. The shares are sold at the end of the trading day’s net asset value and based on the fund’s specific redemption rules. The funds are typically available within one to three days.
• Corporate Bonds can be sold before maturity through a brokerage, with liquidity depending on demand. Like stocks and ETFs, funds are usually available within two to three days after the sale.

Factors that Affect Liquidity

While the previously mentioned assets can be converted to spendable cash fairly quickly, not all assets measure up. Several factors influence how liquid an investment is, from the overall demand for an asset to the specific rules that govern its sale.

Here are the key elements that affect an asset’s liquidity:

• Market Demand: The more people want to buy an asset, the easier it is to sell. Popular stocks or real estate in high-demand areas are examples where high interest can boost liquidity.
• Trading Volume: This measures how much of an asset is being bought and sold. High trading volumes mean more liquidity since transactions are occurring frequently, making it easier to enter or exit investments.
• Regulations and Legal Factors: The rules governing an asset can impact how easy it is to trade. For instance, some investments have restrictions on when they can be sold, which can reduce liquidity.
• Economic Conditions: The overall state of the economy influences liquidity. In a strong economy, assets are generally more liquid because people and companies are more willing to spend and invest. During tough times, liquidity can dry up as everyone holds on to cash.
• Market Depth: This refers to the ability of the market to handle large transactions without affecting the asset’s price. Markets with more depth can support more significant trades, which contributes to higher liquidity.
• Time to Settlement: This is about how long it takes for a transaction to be completed. Faster settlements usually mean more liquidity, as investors can access their cash sooner after selling an asset.
• Transaction Costs: High fees for buying or selling can discourage trading, making an asset less liquid. Conversely, lower transaction costs encourage more frequent trades, boosting liquidity.

Which Investment Has the Least Liquidity?

There is really no one investment type that can be labeled as the least liquid asset – instead, there are several illiquid asset types. Here are some investment options that are considered less liquid:

Real Estate

First, selling real estate is time-consuming. Unlike stocks or bonds that can be sold with a click of a button, real estate transactions involve multiple steps – from listing the property, marketing, conducting showings, negotiating offers, and finally closing the deal. This process can take months or even longer, depending on market conditions.

Another significant factor is the high transaction costs associated with real estate. Selling property involves real estate agent commissions, closing costs, and possibly capital gains tax, which can reduce the overall profit from the sale.

Finally, market conditions and demand for property can vary greatly by location, property type, and economic climate. In a down market, finding a buyer willing to pay the desired price can be challenging, further extending the time it takes to sell.

Hedge Funds

Hedge funds often impose lock-up periods, during which investors cannot withdraw their capital. These lock-up periods can last from a few months to several years. The purpose is to give the fund managers stability and time to implement long-term strategies without the risk of sudden withdrawals.

Another factor is the use of less liquid investments within the hedge funds’ portfolios. Hedge funds may invest in private equity, distressed debt, or other assets that themselves are not quickly sold or exchanged for cash. These investments can offer higher returns but also significantly contribute to the overall illiquidity of the hedge fund.

Third, hedge funds typically have redemption terms that predetermine when investors can withdraw funds, such as quarterly or semi-annually. These periods often require advance notice of withdrawals, sometimes months in advance.

Collectibles and Art

Collectibles and art hold a special place in the investment world, often appreciated for their aesthetic value as much as their financial value. However, the market for collectibles and art is highly specialized, making them another illiquid asset.

Unlike stocks or bonds, which have a broad market with many buyers and sellers, the market for art and collectibles is much narrower. Finding a buyer who appreciates the value of a specific item and is willing to pay the asking price can take time, making these assets less liquid.

Another factor is each piece’s uniqueness and subjective value. The value is often determined by factors like rarity, condition, historical significance, and the reputation of the artist or maker. This makes valuing these items complex and subjective, requiring expert appraisals and potentially leading to wide variances in price expectations between sellers and buyers.

Transaction costs also play a significant role in the illiquidity of art and collectibles. Selling these items often involves auction fees, dealer commissions, or consignment costs, which can be substantial.

Certificates of Deposit (CDs)

When you invest in a CD, you agree to keep your money in the account for the entire term, which can range from a few months to several years. This agreement allows banks to offer a higher interest rate compared to regular savings accounts. However, this commitment also means your funds are not readily accessible until the CD matures.

If you need to access your money before the end of the CD’s term, most banks will charge a penalty, which can eat into the interest earned or even the principal in some cases.

Precious Metals

While precious metals are often considered valuable assets for diversification and as a hedge against different types of inflation, certain characteristics can make them less liquid than other financial assets.

Primarily, the liquidity of precious metals, such as gold coins and bars, can be influenced by their physical nature. While gold and silver have market prices, the exact value of specific items depends on factors like rarity, condition, and collectability. This can make it more challenging to quickly find a buyer at an agreed price, unlike assets with a universally recognized value.

Moreover, market conditions can vary widely based on current demand and supply dynamics. In times of low demand, you might find it harder to sell your precious metals at the desired price, or it might take longer to find a willing buyer, affecting their liquidity.

The location and form of the precious metal also impact its liquidity. For instance, silver coins and bars stored in a secure facility or in another country might not be as quickly accessible as those kept in a local bank or personal safe.

Additionally, larger bars of precious metals may be harder to sell due to their higher value and the smaller pool of potential buyers. Finally, selling precious metals can involve dealer markups and assay costs, reducing the net amount you receive from the sale.

The Benefits of Investing in Illiquid Assets

Although illiquid assets are harder to convert into usable cash, they are still valuable and beneficial assets to include in a diversified portfolio.

Here are the top benefits of investing in illiquid assets:

• Potential for Higher Returns: Because these assets, such as hedge funds and real estate, are not as easily sold or bought as stocks or bonds, investors often demand a premium for the added risk of reduced liquidity. This “illiquidity premium” can lead to greater returns compared to more liquid investments over the long term.
• Lower Volatility: Illiquid assets often experience less price volatility than their liquid counterparts. This stability is partly due to the longer investment horizons and the fact that prices are not constantly fluctuating based on market sentiment. For investors, this means illiquid assets can help reduce the overall volatility in their portfolio, providing a more stable growth trajectory.
• Diversification Benefits: Because the performance of illiquid investments is often less correlated with traditional stock and bond markets, they can offer protection against market downturns, helping to spread risk more evenly across a portfolio.
• Protection Against Inflation: Certain illiquid investments, such as precious metals, have historically provided a hedge against inflation. These assets can increase in value when liquid assets decline in value, helping to protect investors’ purchasing power.
• Regular Income Streams: Certain types of illiquid assets, such as real estate, can generate regular income for investors. This income stream is particularly attractive for investors seeking not just growth but also consistent income over time.

The Risk of Investing in Illiquid Assets

Illiquid assets come with several benefits, especially for investors looking to balance their portfolios. However, they are not foolproof. Here are some risks to consider before investing a large chunk into illiquid assets:

• Limited Access to Funds: The most notable risk is the challenge of quickly converting these investments into cash without a significant loss. This can be a major issue during financial emergencies or when cash is needed unexpectedly.
• Complex Valuation: Determining the value of illiquid assets can be complicated. The lack of a readily available market price means there could be a big difference between what you think the asset is worth and what you can actually sell it for.
• Market Downturn Vulnerability: If the market declines, illiquid assets can be harder to sell without incurring substantial losses. Their prices may also be more negatively affected than those of liquid assets.
• Long-Term Commitment: These investments typically require a long-term horizon. Investors may be unable to react quickly to changes in their financial situation or broader economic conditions.
• Costs and Fees: Illiquid investments often come with higher costs, including management or transaction fees, which can eat into overall returns.

Pro Tips For Managing Liquidity Risk

Managing liquidity risk is a key aspect of building and maintaining a robust investment portfolio. By carefully planning and employing specific strategies, investors can ensure they have access to cash when needed without sacrificing potential returns.

Here are some pro tips for diversifying your portfolio with liquid and illiquid assets:

• Balance Your Portfolio: Allocate your investments across different asset classes, such as stocks, bonds, and real estate, with varying degrees of liquidity. As a general rule, having 10% to 20% of your portfolio in easily liquidated assets can provide a good buffer while still allowing for growth.
• Open an Emergency Fund: Before investing heavily in illiquid assets, ensure you have an emergency fund in place. This fund should cover three to six months of living expenses and be kept in a highly liquid account, like a high-yield savings account or a money market fund. This safety net means you won’t have to prematurely liquidate investments if unexpected expenses arise.
• Leverage Asset-Based Lending: This approach allows you to borrow money based on the value of certain assets you own, such as real estate or art. For example, if you own a valuable painting, you could use it as collateral for a loan without having to sell it. This strategy can be particularly useful in a pinch when you need liquidity but don’t want to sell your assets at an inopportune time.
• Employ the Laddering Strategy: This strategy involves buying multiple financial products like bonds or CDs that mature at different times. Imagine you have $15,000 to invest. Instead of buying one CD, you could buy three $5,000 CDs with one, two, and three-year maturity dates. As each CD matures, you can either access the cash for liquidity needs or reinvest it depending on your financial situation and interest rates at the time.
• Negotiate Structured Settlements: If you’re selling a highly illiquid asset like a business or a piece of valuable art, consider structuring the payment as a settlement over time rather than a lump sum. This may provide tax benefits and a steady income stream while gradually transitioning out of the investment.

Sum-up: Liquid and Illiquid Investments

Balancing your investments between liquid and illiquid assets is like preparing for both a sprint and a marathon in your financial journey. This mix allows you to quickly handle emergencies while also investing in opportunities that grow over time, offering higher returns.

FAQs

Here, we tackle some frequently asked questions to help you understand the nuances of liquidity in investing.

Can Illiquid Assets Become More Liquid?

Yes, some illiquid assets can become more liquid due to changes in supply and demand. For instance, real estate in up-and-coming areas may initially have low liquidity due to minimal market demand. However, real estate prices and liquidity can increase in these areas as demand increases.

Which Investment is Best for Someone Who is Likely to Need Cash Soon?

For those needing quick access to cash, money market accounts or a high-yield savings account might be better suited. Both options offer competitive interest rates with the flexibility to liquidate funds within a few days.

Are Mutual Funds Liquid?

Mutual funds are considered liquid because you can usually redeem your shares at the current net asset value by the next business day.

Is a Checking Account a Liquid Asset?

A checking account is a liquid asset because it lets you access your money immediately.

How Liquid is a Savings Account?

It depends on the type of account. A savings account attached to a checking account is very liquid, allowing immediate withdrawals and transfers. A high-yield savings account is a little less liquid because transferring or withdrawing funds could take a few days.