Definition and Example of Illiquid Assets
An illiquid asset is an asset that takes time to convert into cash quickly without incurring significant expenses. If you have an unexpected expense, you might need to sell assets to gather cash. However, some assets are more difficult to sell quickly without incurring substantial losses than others.
How Illiquid Assets Work
Common factors contributing to the illiquidity of assets include:
- Transaction costs: Higher fixed costs associated with buying and selling assets lead to lower liquidity. Large-cap stocks that you can easily buy and sell using an online brokerage account are highly liquid. However, if the investment is complex enough to require lawyers and brokers, like buying real estate, it is likely to be illiquid.
- Lack of demand: When you want to sell an asset, there may not be a buyer available, making the asset difficult to sell quickly.
- Private information: The seller may have information indicating that the asset will perform poorly in the future, which is not known to the buyer. Due to the risks of unknown information, the buyer may offer a price lower than the market value for the asset.
- Lack of a centralized market: If there is no centralized market for the asset, you may need to negotiate prices and conduct inference. The absence of a centralized market often results in a wide spread between buy and sell offers, meaning buyers are willing to pay less than what sellers want to sell for.
What This Means for Individual Investors
Individual investors may buy illiquid assets because they have the potential to provide reliable returns with lower risks, but they are not ideal for covering emergency expenses.
Financial advisors recommend not investing all of your net worth in illiquid assets. Maintaining some liquidity will give you easy access to cash to cover emergency expenses like car repairs or hospital bills. Keeping liquidity helps avoid selling illiquid assets at a loss or taking on debt to pay your bills if you are unable to sell the assets immediately.
Widely traded stocks, mutual funds, and exchange-traded funds (ETFs) are all considered liquid assets. However, they are not completely liquid because they carry market risks and take some time to sell as well (though it usually is just a matter of days). For example, you could incur significant losses if you need to sell stocks when the stock market is down.
A good rule of thumb is to keep three to six months of living expenses in an emergency fund that contains liquid assets. A savings account is liquid because you can access your money whenever you wish without any penalty. Although slightly less liquid than a savings account, you can also keep your emergency fund in other liquid assets such as short-term certificates of deposit, treasury bonds, or money market mutual funds.
Key Takeaways
- An illiquid asset is one that cannot be quickly and easily converted into cash.
- An asset is considered illiquid if it lacks a ready pool of buyers or if there are significant costs associated with selling it.
- Real estate can be one of the most common types of illiquid assets.
- It is advisable to maintain some liquidity to cover emergency expenses and avoid selling illiquid assets at a loss or incurring debt.
- Liquid assets can provide a way to diversify a portfolio.
- You should keep three to six months of living expenses in an emergency account containing liquid assets.
Source:
https://www.thebalancemoney.com/what-is-an-illiquid-asset-5199375
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