Liquidity is a topic overlooked by many beginner and experienced investors. In the modern world of instant communication, free movement of capital and information, we can easily forget or overlook the ease of buying and selling an asset.
Some markets are more liquid than others! A modern stock market can be a wonder to behold as money changes hands at lightening speed. However, this money is mainly moving into and out of the largest listed companies. Stock market indices are weighted meaning that the largest firms have a bigger impact on the market than smaller ones. This, of course, makes perfect sense.
Very small markets, such as in Malta are likely to not have high liquidity.
These larger companies also have more shares in issue and more stockbrokers trading in the company. This makes perfect sense. However, many overlook the other end of the market. Lots of small quoted companies are actually very illiquid – meaning that trades happen only rarely. If you need to sell in a hurry, you might simply be unable to.
It is also worth noting that on occasions – usually times of panic – stock exchanges have been known to close. Sometimes for days at a time. In fact, during the Second World War, many exchanges closed for years. The holdings were the same when the market reopened, but they were generally at very low levels. It is curious that markets never shut because they are rising too quickly! We don’t hear the cry, “Stop making me money!” However, the impact that a falling market can have on a national economy is severe – which is why authorities sometimes choose to close markets completely.
If the subject of stock exchanges and war interests you, we can recommend the excellent Wealth, War and Wisdom by the legendary Barton Biggs. His book discusses many aspects of investment in troubled times. It is interesting how few asset classes he believes are able to protect and enhance wealth during the worst of times. In fact, the assets he finds were mostly the best are not assets that many people hold – farmland for example!
In times of great distress, most asset classes fail the liquidity test. This means that they are either traded at a fraction of their previous value, or they simply cannot be traded at all! This is quite a worry for anyone with significant assets and one reason why he believes small farm holdings are a good bet – after the distress, the land is still there and during the distress it was possible to feed oneself.
In other markets, liquidity is less visible even in the best of times. High quality art, for example, requires an auction and preferably the right auction to attract the right buyers. These events may not happen even annually.
Another good example of a possibly illiquid market is residential property. A residential property for sale is usually awaiting the buyer that falls in love with it. This person may or may not be evident. In addition, pricing and mortgage availability may have a significant impact on the price that can be achieved.
As someone that has worked professionally within the financial part of the property industry, your author can confirm that many transactions are at less than perfect prices. Buyers that negotiate hard when the market is with them can save significant amounts. On the flip side, in a strongly rising market, sellers can achieve almost any price they choose with seemingly no reference to the underlying value! This happens because of imbalances in liquidity.
When valueing a property, a former colleague used to prepare with three prices (taken from recent sales for comparison) before an appointment. The first price was ‘Top Dollar’ if the property was in excellent condition. The second was ‘Market Price’ if it was a good example and ought to obtain it’s actual worth. The last was ‘Dump’ for properties in poor condition or those needing a quick sale. There would generally be at least 15% between the top and bottom numbers.
So when buying an investment, it is important to think about how easy it will be to sell it as well. If you need to sell in a hurry, will that be possible? If it is, what will it cost? Can you accept that cost? When might you plan to sell? What will the market be like then?
The answers to these questions will of great assistance to any beginner investor or experienced market operator and as such is a vital part of any beginners guide to investing.