‘Liquidity risk’ probably sounds like something technical that most investors don’t need to worry about. In reality, however, it is something that is likely to affect everybody at some point.

The liquidity of an investment refers to how quickly it can be sold. Shares in Apple or Amazon are highly liquid because hundreds of thousands of them are bought and sold every day.

A sheep farm in the Karoo, on the other hand, is a lot less liquid. There aren’t as many of them, for a start, but there also aren’t thousands of people lining up on a daily basis to get their hands on one. If you own one and want to sell it, it will therefore take a lot longer to find a buyer.

Managing losses

This is important to investors because if something cannot be sold quickly, it becomes very difficult to prevent or minimise a loss. If you own shares in Apple, even if they drop sharply, you should have little trouble selling them. You can therefore manage how much of a hit you actually take.

On the other hand, if the bottom falls out of the sheep farm market in the Karoo, disposing of that property at a good price could be almost impossible.

What is important for any investor is to remember that any asset is only worth what you can sell it for. And if you have to sell something in a hurry, if it is not liquid, you may find yourself getting a lot less for it than you expected.

A good example is property. Your home might be valued at R2 million today, but if there is a downturn and you need to sell, you are unlikely to get that much.

This is what happens with distressed property sales. People are so desperate to liquidate their houses that they are willing to take much less than they are actually worth.

No value at all

But liquidity risk can go even further. If an asset is only worth what you can sell it for, it follows that if you can’t sell it at all, it is worth nothing.

This is a risk that many people putting their money into ‘alternative’, unregulated investment schemes fail to appreciate.

In a unit trust, you have guaranteed liquidity. If you ever want to buy into or sell out of one of these funds you will always be able to do so. That is how they are structured.

But lots of other so-called ‘investment opportunities’ don’t offer the same guarantees. There are plenty of examples.

No value at all

But liquidity risk can go even further. If an asset is only worth what you can sell it for, it follows that if you can’t sell it at all, it is worth nothing.

This is a risk that many people putting their money into ‘alternative’, unregulated investment schemes fail to appreciate.

In a unit trust, you have guaranteed liquidity. If you ever want to buy into or sell out of one of these funds you will always be able to do so. That is how they are structured.

But lots of other so-called ‘investment opportunities’ don’t offer the same guarantees. There are plenty of examples.

By Patrick Cairns

Author for Findotnews

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