[t]he degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.
The key phrase is “without affecting the asset’s price.”
Liquidity is not a characteristic of the underlining asset, but depends on the circumstance in which the asset is traded and the direction you want the asset to go. When there are more buyers than the sellers, it is easier for your sell order to be filled, and therefore it is liquid to sell the asset. On the other hand, it is harder for you to buy the asset at the current price, and therefore, buying position is illiquid; buying takes a long time to fill, and you may have to accept a big discount.
It is highly situational; an asset may be liquid one day and illiquid a few days after. This transition usually coincides with a black swan event. Take an event in January for instance. When Swiss Central Bank unpegged the Swiss Franc (CHF) from the Euro (EUR), suddenly there was a flood of sellers of EUR, and essentially no one to buy it with CHF. Within 30 minutes, EURCHF fell by 30 percent. If you borrowed CHF to invest in EUR, you would find that EURCHF became illiquid in a short period of time and you would have to sell EUR at a significant discount.
So, it is worth bearing in mind that an asset that is currently liquid may be illiquid when you need to sell, because everyone else also wants to sell. Howard summed it up nicely.
Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when your need liquidity most, it tends not to be there.
Why? A simple answer is our herd mentality. We tend to follow the other people in a group as we feel the safety in number.
Overly concern of illiquidity can hinder your portfolio performance too. In Howards’ words: liquidity isn’t free. There’s usually a cost, and it comes in the form of return forgone. The best way to manage the issue of liquidity is to diversify your portfolio according to the degree of liquidity. Ideally, you shouldn’t take more risk from illiquidity than you can afford to.
What does this mean for an average investor?
- It is worth paying attention to your own assumption on liquidity, your ability to get out of the market when you want to.
- When the price is falling, buying is usually easier, and therefore more liquid. It is usually the best time to buy an asset since in Howard’s words: to achieve “immediacy” (a quick exit), the sellers tends to sacrifice something else – price. By supplying liquidity when a demand is in short supply, we are more likely to be financially rewarded.
- Look to ride a period of illiquidity. Do you really need to close your position when it isn’t in your best interest? If not, then maintain your composure and stay in the market, and ride it out.