Liquidity Risk for Investors

Liquidity is an extremely important consideration when analyzing investments.

For investors, liquidity relates to the ease in buying or selling an asset. By ease, how quickly are you able to trade and how close in price to fair market value.

Time delays, lack of a ready market, lack of volume, and fluctuations in pricing, make it difficult for investors to minimize their purchase costs or maximize their sales prices.

Time and Liquidity

The longer the period in which you may buy or sell, the more patient you can be in waiting for the best price. The less time you have, the greater the probability that you will pay more or receive less than you wanted.

For example, you owe your bookie $7000. Being a generous person, he has given you 90 days to pay your debt. Your only option is to sell your car. Professional appraisals conclude market value is $10,000, so you list the vehicle at $10,000.

Demand for used cars is weak and no one wants to buy your vehicle. You get a call from your bookie telling you that there are only 30 days left. You decide to lower the price to $9000, 10% below market. Still no takers.

As the days continue to pass, fearing for your personal safety, you lower the price even more. Finally, with 2 days left, you sell the car for exactly $7000.

You avoid a visit to the emergency ward and repay your bookie.

While only an example, the relationship between time and price applies to any asset. It also shows that fair market value in theory and in practice can differ.

Note that in options trading, time is a key consideration in the option’s price. The longer the expiration date, the more valuable the option based on that time frame. As you approach expiration, time becomes less a factor and the option will be priced based on its actual value (market price of asset minus strike price).

Price Volatility

Liquidity may also be affected by price volatility.

The greater the price volatility the greater the potential impact on liquidity. At least in the area of being able to buy or sell at the expected price.

Factors that affect volatility include: asset supply and demand; an efficient and effective market to trade the asset; the uniqueness of the asset; the ability to effectively value the asset.

Considerations When Assessing Liquidity Risk

To avoid confusion and undue post length, we shall limit the considerations below to common financial instruments such as stocks and bonds. In a future, separate post I shall briefly highlight some liquidity issues for more exotic investments.

Here are a few questions you should ask when considering the liquidity of any potential investment.

How is the financial instrument bought and sold?

If shares in a company, are the shares listed on a major stock exchange (e.g. New York Stock Exchange), on a minor exchange, “over the counter” (no formal exchange), or are the shares in a private company?

The larger and more formal the marketplace, usually the greater the liquidity.

How homogeneous is the asset?

Stocks or bonds in a company are homogeneous. That is, each unit is identical to all others of the same class.

The more homogeneous the asset, the greater the liquidity of the asset.

100 Class A common shares of IBM is worth 10% the value of 1000 IBM Class A common shares. There is not a similar parallel between IBM Class A and Class B shares. Nor is there a sameness between IBM Class A and Dell Class A. But within an individual company’s specific offering, each unit is identical.

If you buy a car, you want to see it before you purchase it. Each car, even those of the same model and year, may be different in some way. With stocks or bonds, you know exactly what you are receiving. You do not require a physical inspection. This is the reason that financial instruments can be widely traded on exchanges.

Also, because there is no difference in assets, valuation is simple. Each share of IBM is exactly the same, so it is valued identically. Try taking 10, 1 carat diamonds and assigning the same value to each. It will not work. In fact, there might be an enormous range between the lowest and highest quality stones.

What is the quantity of the financial instruments?

If you want to buy shares in a company with only 1000 issued shares, it will be much tougher to find a seller from whom to purchase shares than if the company has 10,000,000 shares available.

The greater the number of freely tradable shares, bonds, or other financial instruments, the easier it will be to trade.

Note that there is a difference between “authorized”, “issued” or “outstanding”, and “freely tradable” financial instruments.

Authorized is the maximum amount that the company is legally allowed to create. This can be amended from time to time by shareholder consent.

Issued or outstanding is the number of shares that have actually been created. At most this will be equal to the number of authorized shares. Often it will be less than the authorized level. The issued shares includes both freely tradable shares and any restricted stock that exists.

Freely tradable shares, also known as the “float”, is the key quantity for investors. This is the amount of shares that are available for trading each day. There are no restrictions that prevent trading.

When considering the quantity of shares, focus on the float. Be less concerned with the authorized or outstanding shares.

What is the most recent asset price?

The price of an asset may affect liquidity. The higher the price, the less potential purchasers there might be.

If you wish to sell a new Hyundai Accent, its price would cover every potential new car buyer. However, if you plan to sell a new Bugatti Veyron, you might find significantly less interested customers.

Although this is usually less of an issue with shares, there are still some examples. If you wish to sell 1000 shares of Berkshire Hathaway A shares (valued at about USD 250,000 per share) you might find fewer buyers than if you were selling 1000 common shares of Ford (valued at about USD 11 per share).

Many publicly traded companies “split” their shares when the price reaches a certain psychological price level. For example, when the share price reaches $100, the company may split its share price 10 for 1. That gives every shareholder 10 times the number of shares previously held. The “new” share price should reflect the split and trade at $10 per share.

There are a variety of reasons why companies split their shares. These include: increased liquidity by enhancing the total shares outstanding; commissions and listing issues; improving ease for buying by small buyers; belief that lower priced shares perform better than higher priced ones.

What is the daily trading volume?

The average trading figures tells you how many shares are bought and sold each day.

The greater the average volume, the easier it will be to find buyers or sellers.

Even if the float is relatively large, many shares may be held by a few investors who never plan to sell. This may serve to significantly reduce daily trading and make it more difficult to buy or sell shares.

What is the spread between the bid and the ask prices?

The bid is the highest current amount a buyer is prepared to pay for a share. The ask is the lowest amount that a seller is prepared to accept for a share.

The greater the difference between the two, the less likely a trade will occur.

It is only when the bid and ask prices meet that a trade can be made.

So the narrower the spread, the better the liquidity.

For example, you want to sell your car for $10,000 (ask price). Three people are interested in the vehicle. One offers $8000, another $9000, and the last $9500 (bid prices).

Unless you are prepared to reduce your own asking price to $9500 or a buyer raises his bid to $10,000, the sale will not be consummated.

It is exactly the same with any financial instrument or other asset. Until two parties agree on a price, no transaction can be completed.

With many financial instruments, well established markets exist to bring many buyers and sellers together from around the world. This greatly increases the chances (and speed) of matching a buyer and seller who can agree on a final price.

Also, many investors simply buy or sell their shares “at market”. In our car example, that means you would buy at the ask price of $10,000.

What are the volumes at the highest bid and lowest ask prices?

You want to determine the impact to the overall share price if you engage in a large transaction.

The greater the volumes available at the highest bid and lowest ask prices, the better the liquidity.

For example, you own 1,000,000 shares of ABC that closed the day trading at $10 per share. Your market value is $10,000,000. You decide to sell the shares and buy a villa in Spain with the proceeds.

You call your broker and find the current bid price is $10. You place a “market order” (an order to buy or sell at current market conditions with no restrictions) to sell all your shares, open a bottle of Rioja, and settle in to await your money.

Unfortunately, neither you nor your broker reviewed the bid volumes.

While the highest bid was at $10, it was only for 1,000 shares. The next closest bids were: $9 for 100,000 shares; $8 for 100,000 shares; $6 for 200,000 shares; $3 for 600,000 shares.

At the end of the day, you only net $4.7 million before commissions and taxes. A far cry from your expectations.

When buying or selling “at market” know what the market prices actually are for the volume you are trading. This is usually only a problem if buying or selling an extremely large quantity. Or if the financial instrument is very thinly traded.

Investment Bubbles

Even if all the answers above are positive, you still may face liquidity problems.

If the market crashes or an investment bubble bursts, there may be too much selling by investors so that you are unable to get a fair approximation of pre-crash prices.

I will likely write something on investment bubbles as they may become topical in the next year or so.

I hope you can see why liquidity is a key concern for investors.

When investing, please ask yourself these questions when analyzing any financial instrument. It may save you some money on the purchase and help maximize your return upon sale.