What is Liquidity?
Liquidity measures how easily an asset can be sold at a fair price. Cash is the most liquid asset. Large-cap stocks on major exchanges like the NYSE or TSE can be sold in seconds with minimal price impact. Real estate, private equity, and collectibles are illiquid - selling a house typically takes 2-6 months and involves 3-6% in transaction costs. The bid-ask spread is a practical measure of liquidity: highly liquid stocks have spreads of $0.01, while illiquid stocks may have spreads of $0.50 or more.
Liquidity Risk
Liquidity risk is the danger that you cannot sell an asset when you need to, or can only sell at a steep discount. During the 2008 financial crisis, many mortgage-backed securities became virtually unsellable. Even normally liquid markets can seize up during panics - some bond ETFs traded at 5-8% discounts to their net asset value in March 2020. Illiquid investments often offer a liquidity premium of 1-3% higher returns to compensate for this risk.
Key Considerations
Always match your liquidity needs to your investment choices. Money you might need within 1-2 years should be in highly liquid assets like savings accounts or money market funds. Retirement savings with a 20+ year horizon can tolerate illiquid investments. ETFs generally offer better liquidity than mutual funds because they trade throughout the day, while mutual funds only transact at end-of-day NAV. Never invest emergency funds in illiquid assets.