With investing, it is always best to know about the risk factors that could come into play at any point when you were trading. One of the things that many new traders don’t realize is that they could get themselves into quite a bind if they are to invest in something known as an illiquid asset.
An illiquid asset is not a specific type of investment, but rather a category of investment in which the trader is not able to get in and out of their trade very easily. Referring to something as “illiquid” means that there is not a lot of trading volume in that specific asset. There may not be a lot of interest in the asset itself, or it may be difficult to obtain and/or trade.
Why are illiquid assets dangerous?
Ideally, one always wants to trade in assets that are as liquid as possible. That is to say that they can cash out of their investment at any point in time by selling it off to another investor who would like to purchase it. This means that an investor may make the most rational decisions based on their own needs for cash at that moment versus their need for holding the investment.
When too much money is tied up in illiquid assets, it makes it difficult for the investor to receive their funds in a timely manner should they decide that they need to liquidate their positions temporarily and reassess their financial position.
What kind of assets are illiquid?
Any type of asset can be potentially illiquid, depending on the characteristics of the market that it trades in. Generally speaking, assets that are considered illiquid are things that are difficult to sell or take some time to complete a transaction. As such, one may think of something like a piece of real estate, a trading card, a piece of art, or some other asset that doesn’t necessarily have the largest market available.
These assets are much more difficult to get out of than say something like a share of stock in a company. A share of stock in a company is easy to trade in and out of because there are willing investors just around the corner, always ready to step in and purchase your shares. The same cannot necessarily be said about your home, your art, your trading cards, or other potentially illiquid assets.
Can stocks also be liquid?
It is certainly the case that you should not lull yourself into the belief that stocks are always as liquid as they may seem. There is usually a buyer available for most sellers in most stocks at most times. However, there are some small-cap stocks or penny stocks that may not generate the kind of attention necessary to keep them liquid at all times. It can be fun to try to trade in these types of stocks and generate a nice return for yourself. However, you should be aware that you may not be able to get out of your trade as quickly as you could if you were trading a much more well-known company. The risk of being caught up in an illiquid asset with penny stocks is very high.
Always know what you were trading
Before you purchase any type of investment, you should always check to see what kind of liquidity that investment may have. You don’t want to get caught up in something that doesn’t provide you with the liquidity that you expect and need. Make sure that the majority of your investments are held in assets that are highly liquid and that you can get out of as needed at any time.