All investors face some level of potential liquidity risk. Some securities are more prone to liquidity risk than others. In an effort to manage liquidity risk, there are particular characteristics that you can look out for. Let’s walk through them.
No Secondary Market
A secondary market is one where a security can be bought and sold aside from the issuing company. In contrast, a primary market only exists to issue securities. An example of this is an IPO for a stock, which is distributed/sold in the primary market. Thereafter, the stock is traded on stock exchanges, which are secondary markets.
Some companies will create a secondary market for private issuances that are not traded on public markets. While that can benefit investors who might want to sell their securities before maturity, these private secondary markets are generally very illiquid. Investors can often expect to incur high transaction costs and potentially a loss on the value of their security when being sold.
Some securities are issued with the expectation that investors will hold them until maturity. For these securities, they may not have a secondary market. In that case, the investor really has no choice but to hold the security until maturity. Depending on the issuing company, there may be conditions in which the investor can liquidate their security. Still, it will usually come with high transaction costs and a large loss to the value of the holding.
Large transactions can sometimes be associated with illiquidity. This is often the case in the private real estate market. Selling or buying a residential or commercial property is not a quick transaction. If an investor needs cash from their property immediately, their options are very limited. Of course, being a large transaction is not the only factor that affects real estate liquidity.
Liquidity risk for large transactions exists in the stock market as well. Banks and hedge funds trade stocks in large lots. Sometimes they trade in public exchanges, but many times, they'll coordinate these transactions so that prices are negotiated.
If a large investor tried to sell a large block of shares on the open market, there's a good chance that the investor will not sell all shares quickly. They'll also probably push the price down, selling shares at a lower cost. That's why these investors try to negotiate the price for their large transactions. It helps them better manage liquidity risk.
We discussed maturities above and how selling before the security matures can be a detrimental decision. Bonds have this problem as well. Long-term maturity bonds are often not as actively traded as short-term bonds.
When an investor tries to sell these bonds, he may find out there aren’t many buyers. The bid/ask spread on these bonds will be wide, which creates inefficient prices.
Even for a security that doesn't have the above problems, it can run into demand issues because of changing market conditions. A once hot security may have run its course and fallen out of favor.
Those who bought the security while it was hot probably paid a high price because of demand. Once the security has cooled off and demand has dried up, the price will likely have dropped. Investors wanting to convert the security into cash now face the reality of taking a loss.
Understanding a security and its related market can help determine if the security will remain in demand in the future. Of course, predicting the future, especially long-term, is difficult. There can be unexpected events that turn the tide against the security.
But that is the nature of investing — with rewards come risk. Trying to balance those out is the tightrope that investors must walk.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.