In a NutshellLiquidity describes how easy or hard it is to turn an asset or security into cash. A more-liquid asset means that it’s easier to get more of the value of the asset in cash quickly.
Whether you are evaluating your investments or calculating your overall financial situation, liquidity is important to understand.
Simply put, liquidity refers to how quickly you can convert something to cash and still maintain its value.
Assets can be bought or sold, either as short-term or long-term investments. The level of liquidity of any particular asset depends entirely on how quickly it can be sold and converted to cash of equal value. An asset that takes longer to sell and for less than full face value is considered less liquid (also referred to as illiquid).
Read on for examples of assets and their level of liquidity.
Liquidity and assets
The asset classes below are organized from most liquid to least liquid.
Cold hard cash is the most-liquid asset. Cash does not require any type of conversion and maintains its value. It’s wise to have cash available as an emergency fund, because you almost always have access to it when you need it, without waiting. An example of liquid cash is a savings account where funds can be easily withdrawn — whether from a local bank or ATM. Checking and money market accounts also permit easy access to your funds.
Securities are assets like stocks, bonds and treasury notes that can easily be converted into cash. But how quickly you can sell the security — and how much you lose in value — can vary based on the security.
For example, if it’s a marketable stock, sold on a main exchange such as the New York Stock Exchange, you may be able to sell quickly without taking a hit. But if the stock isn’t as marketable, it could take time to sell and you could take a bigger loss.
Fixed assets are longer-term or permanent investments — things like vehicles and real estate — that make more sense to use or hold onto for a while before converting them into cash. Fixed assets are considered less liquid.
Think about it this way: If you need to sell a house quickly, you may have to accept less money for it than if you were able to wait for the right person to come along and pay the full value. That’s why it’s considered a fixed — or less liquid — asset.
A word on diversification
We have all heard the saying, “Don’t put all your eggs in one basket.” This also applies to the three major liquidity-of-asset classes: cash, securities and fixed.
In fact, while investment portfolios should be unique to each individual, the Securities and Exchange Commission emphasizes a big rule of thumb for everyone: having a diverse set of assets. That’s because, historically, the returns of the three major types of assets don’t move in lock-step. In fact, market conditions that are good for one type of asset are often bad for another. Having diverse assets can help protect individuals from significant losses across the board if something catastrophic happens in the market.
Investing in more than one type of asset also broadens a person’s options in case there’s a need for immediate cash.
Understanding your financial assets and their levels of liquidity is important. Life is long — and it can throw you financial curveballs. Investing in all sorts of asset classes may help keep your finances more stable, whatever comes your way.