Illiquid is a term used to identify securities or assets that can’t be easily disposed of through a sale. On the other hand, liquid assets refer to things that can quickly be turned into cash without losing their value, which includes cash itself.
To cover various living expenses and any potential emergency, you’ll want some of your assets to be liquid. In the long run, however, it’s best to think of liquidity as a scale, where some assets should be readily convertible into cash. On the other end of the scale lies your illiquid assets where they can’t be readily sold for cash.
While illiquidity is mostly used for business and finance, the concept also applies to your assets. Illiquid assets can’t be sold easily or quickly converted to cash, so they may stay with you for months or even years before they are sold. This condition occurs where there isn’t a market-ready for the assets or has a limited number of buyers.
The most basic example of an illiquid asset is your house, as it may take some effort to sell it and you may not know the exact value of the house until the price is agreed upon between you and the buyer.
When it comes to illiquid assets, the shortage of ready buyers can lead to huge discrepancies between the asking price (from you, the seller), and the bid price placed by the buyer. This big difference will lead to a wider spread in the amount of the bid compared to that of the asking price which wouldn’t normally happen in markets where there is daily trade. This lack of depth in the market is what can cause you to experience loss from your illiquid assets, especially if you desperately need to sell assets quickly.
Due to the value of illiquid assets being hard to determine, they hold a higher risk compared to liquid assets. This is known as liquidity risk and is especially true in times of turmoil in the market when the amount of sellers far outweighs the ratio of buyers. When this happens, you might find yourself unable to get rid of your illiquid securities, or you might be able to sell them but also lose money in the process.
Furthermore, an illiquid asset may need you to add a liquidity premium to cover the fact that it can’t be easily sold by the buyer later on. When times of financial panic strike, credit facilities, and markets could become jammed, causing a liquidity crisis. When this happens, even sellers of liquid assets can find it difficult to find buyers to make a fair purchase.
As discussed above, illiquid assets pertain to anything that can’t easily be converted or sold to get cash. Here are just a few examples:
- Real Estate: While it may be possible to get access to the equity you’ve built up on an investment property or a home, the process can take time. A home equity loan, a reverse mortgage, or a home equity line of credit can’t be converted into cash quickly. As a result, it may take you weeks, months, or even years before you can sell real estate.
- Private Equity: If you’ve invested in private equity assets such as funds of funds or venture capital, you have a great potential to earn big. Unfortunately, private equity funds will often come with restrictions regarding when you can sell your shares.
- Estates: If you have any estates to your name, it can take years before you fully benefit from it. First, taxes will need to be assessed and debts will need to be paid before you can get any access to the assets within an estate.
- Collectibles: Various assets such as artwork, antiques, jewelry, baseball cards, as well as other collectibles can be hard to value and sell.
- Intangible Assets: These refer to any ideas or concepts that might have value. In some cases, these may even be worth a whole lot. This category includes reputation, intellectual property, brand recognition, and corporate goodwill. These, however, can be extremely difficult to value and are extremely illiquid by nature.
However, keep in mind that the liquidity of any asset can change over time since this depends on influences outside of the market. Price changes are particularly true for collectibles because the popularity of an item can significantly fluctuate in the consumer market. As such, pricing can be highly volatile, so nothing is guaranteed.