How To Assess the Liquidity Of An Asset

The liquidity of an asset refers to how quickly it can be converted into cash. For example, a $10,000 money market account (“MMA”) is more liquid than a rare coin collection valued at $10,000. If you wanted to take your money out of the MMA, it is simple to make a withdrawal or close the account. However, if you wanted to sell your rare coin collection, you would have to find people who would be interested in paying $10,000 for it and make a sale yourself, which could take time waiting for the right buyer to come along.

Before you make an investment, it is important to understand the asset's liquidity. If money gets tight and you feel pressure to sell the asset down the road, you may not find a buyer willing to pay full price when you need the funds. This could lead to selling the asset at a loss. The good news is that there are some simple questions to ask to determine how liquid an asset is.

Is the asset simple or complicated?

Some assets are reasonably simple to understand. Buying a house, for example, is a straightforward process. Sure, there is a lot of paperwork and moving pieces; but at the end of the day, money is exchanged for ownership of property. Buying a mortgage-backed security, on the other hand, is an investment that uses one or more mortgages as the collateral backing the asset. That is a much more complicated investment that may be more difficult for the layperson to understand. The complicated assets however, is more liquid.

What is the price momentum of the asset?

Price momentum refers to how quickly the asset changes in value. When the value of assets begins to rise quickly, the market may become more volatile as investors adjust their strategies. If the price momentum of an asset is going up, it could be a sign that the liquidity is going down.

These are just a few of the ways to determine how liquid an asset may be. An illiquid asset is not inherently a bad thing to invest your money in. However, it is important to have a greater understanding of how illiquid investments fit into a balanced overall portfolio.