Illiquid

Publication Date :

01 Jan, 2021

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Table Of Contents

Illiquid Meaning

Illiquid refers to an asset that cannot be quickly converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. In other words, it is an uphill task to sell such assets owing to the utterly low trading activity due to a lack of investor interest. Bonds, stocks, and properties are some examples of illiquid investments.

Illiquid Meaning

Explanation

Due to a low trading volume, illiquid assets tend to have a wider bid-ask spread. A huge difference between what the seller quotes as the asking price of an illiquid asset and what the potential buyer is willing to pay results in a wider bid-ask spread.

It happens because of the absence of readily available markets for such assets. Sometimes, the insufficient market depth and lack of willing buyers lead to significant losses for the owners of the illiquid assets.

Some examples of Illiquid Assets

Bonds and stocks
Real estate properties
Motor vehicles
Antiques
Investment in privately held companies
Shares of small-cap companies
Various types of long-term debt instruments
Some of the collectables and art pieces

All these items indeed have a certain intrinsic value, but a sizable amount of money is required for their purchase. Moreover, investors often develop cold feet at the mere thought of having their money locked up for a long time in such investments. Together, they often dissuade investors or buyers from making such investments.

Why Invest in Illiquid Assets?

The answer to this question is simple. Sacrificing liquidity is considered a sound investment strategy by some investors who hope to reap a relatively higher yield. Therefore, the possibility of high earnings can compensate for the inability to trade easily.

So, how much extra return can justify such types of investments?

There are no thumb rules for the extra return, and it purely depends upon the type of investment security and its extent of illiquidity. For instance, small-cap stocks exhibit erratic trading volumes at the exchange, making them illiquid. So, the investors try to buy these small-cap stocks at a lower price-to-earnings (PE) multiple and earn a higher return on investment.

While making investments in privately held companies that don’t trade on any exchange, the investors ask for higher risk premiums. Mostly, professionally managed funds invest in these companies with a long investment horizon. The investors have limited freedom to move out of the investment before the funds' maturity.

Illiquid and Risk

Illiquid securities come with an inherent risk, which leads to liquidity risk. The investor learns of the risk when the market is extremely stressed. In such a scenario, the equilibrium between the number of buyers and sellers goes haphazard. Owners find it difficult to sell off their assets without significant losses. Therefore, the buyers often seize the opportunity by charging a heavy liquidity premium to compensate for the limited liquidity.

Benefits

Illiquid assets can be a worthy investment for those looking for a long-term investment. They give a higher yield in the future, compensating for their illiquidity.
Assets like real estate properties grow in value over time, reducing the impact of inflation.
Sometimes, the investment in a privately held company gives better returns than a publicly traded company as the former comes at a significant bargain.

Limitations

Aside from the liquidity risk, these assets come with more risks for their investors. The liquidity premium offered on an illiquid asset is too low. Also, the provisions created against these investments take away a significant portion of their value.

Key takeaways

Illiquid assets suffer from a valuation loss when sold in the market in exchange for cash. Some examples of such assets are stocks, bonds, and properties.
Investors need to exercise caution as they come with liquidity risk.
Such assets earn higher returns in the future which compensates for the liquidity risk.