As the name suggests, liquidity is used to describe the ease and speed of transacting assets without compromising the asset’s value. Based on this simplified definition, money, or cash, is the most liquid asset as it can be used for immediate transactions without any loss of value – this is why cash is considered the standard for liquidity. Other kinds of liquid assets would be savings bonds, certificates of deposit, and even shares of stock; these assets can be traded in for money or cash very quickly with very minimal loss in its original value. Examples of illiquid assets would be old comic book collections or Harry Potter memorabilia – these assets cannot be quickly sold for other goods and services without a significant cut from its original value. For most non-cash assets, there is a trade-off between the speed to transact, and the loss of value of the asset.
Sometimes, it’s just about the speed
As mentioned, the speed to convert your assets into cash is one of the main determinants of your asset’s liquidity. With this in mind, it would be good to note that even though your initial offer and your initial bids closely match, your asset may still be deemed illiquid if the process is cumbersome and lengthy. Real estate is a good example of how an asset that can receive initial bids close to its original value, but still be deemed illiquid. Due to the copious amount of paperwork and legal administration required to close the sale of your property even though initial bids match your offer, real estate can still be classified as an illiquid asset since it takes a really long time to convert it into cash.
In the market, it all boils down to bids and offers
With regards to stocks being traded in the market, the liquidity of an asset is essentially subject to the bids and offers. Here’s an example of how this works:
A seller wants to liquidate his shares of a company and pushes out an initial offer. The market responds with varying bids. If the initial bids match the seller’s offer, the asset can be described as liquid (no loss in asset value). However, if the initial bids fall far from the seller’s offer, the asset is then said to be illiquid.
The bid-offer spread
The difference between the seller’s offer and the buyers’ bids is known as the bid-offer (or the bid-ask) spread. The bigger the difference between the bid and offer, the larger the spread. For example, if the seller puts out an offer of $12, and a buyer puts out a bid of $10, the bid-offer spread in this scenario would be $2. The size of the bid-offer spread for a particular stock determines the liquidity of that particular stock – the bigger the spread, the less the liquidity.
It is important to pay attention to the bid-offer spread, as it directly affects your profits and losses when you are trading. Evaluate the bid-offer spread when trading in the market in order to mitigate losses and maximise profits.
Best Bid Offers (BBOs)
Since most people would want to buy and sell to fulfil their own interests, theoretically, the bid-offer spread in the market should appear to be incredibly elastic. In order to regulate the liquidity of stock, and to minimise the variance of the bid-offer spread, the Securities and Exchange Commission (SEC) has ensured that market players guarantee that they quote the best (lowest) available offer and the best (highest) bid to investors. The average of these bids and offers is known as the ‘best bid offer’ – a good benchmark for market makers to set their expectations against.
When examining your investment portfolio, it is good to keep in mind the liquidity levels of your assets. As you would expect, illiquid assets can produce higher returns than liquid assets because of mispricing due to illiquidity, but having the freedom to convert assets into cash is important in times of urgency (crisis, sudden changes in market, etc.).