Back

Managing liquidity

Lesson in Course: Investing basics (advanced, 4min)

I am ready to start investing. Do I dive right in with all my money or dip my toes in the water first?

Eureka!

What it's about: The size of the market for an asset.

Why it's important: Understanding liquidity requirements can have lasting impact for our future.

Key takeaway: Don't rush into investments without understanding them. Don't keep your money in all cash.

As we are starting to invest for the first time, folks will find themselves asking how much should I invest? And how quickly should I invest it? These are all very important questions that touch on a need to gain an understanding of what is liquidity and how to manage our liquidity

What is Liquidity?

In the investing world, liquidity is the ability to convert investment assets into cash.

Being able to quickly convert investments to cash gives us many advantages.

Liquidity advantages

  1. Allows us to seize opportunities on great investments faster
  2. Allows us to better manage our risk in a market crash
  3. Allows us to be better prepared for emergencies

Depending on the liquidity of our potential investments, investing a significant amount of our money all at once can result in a loss of the advantages listed above.

What makes an asset liquid?

Liquidity requires other investors

An asset is liquid when it has a very large market. Having a market with ample supply and demand enables investors to sell their investments for cash relatively easily. 

Example of a liquid asset

A liquid asset is the S&P500 ETF.

The average daily trading volume is 70 million shares!

Illiquid assets have small markets and limited supply and demand. These assets take a long time to sell and prices and fluctuate wildly.

Example of an illiquid asset

Mansions are an example of an illiquid asset. There are not many people who can afford mansions so the demand is low. There are far fewer mansions compared to regular homes and so the supply is also limited.

Mansions take a long time to sell and cannot be converted to cash easily. As of right now Michael Jackson's Neverland Ranch still isn't sold.

We can bucket lists of available assets by the size of their markets and liquidity.

Liquidity categories

It may be surprising for us to see crypto in the least liquid category. While BTC and ETH have fairly liquid markets, compared to cash and traditional investments the market is still relatively small. We can expect this to change as more people adopt the use of crypto.

Starting out, we want to manage our liquidity and make sure we aren't rushing to convert our most liquid assets into illiquid assets.

 

Cautions of opportunity cost

Being stuck in illiquid assets or in speculative liquid assets with losses create situations where we can lose money due to opportunity cost. Opportunity cost is explained in this short video.

The road not taken
http://youtube.com/embed/SA16Qw09bXM?start=1&end=176

Like the analogy of the man with the firework, our opportunity cost is having our money invested in an asset that returns less than a new investment opportunity we've identified. If we don't have the cash and can't convert our current investments into cash quickly, we would have lower long-term returns. We run into the risk of this if we rush into investments.

Managing liquidity requires proper planning

On the contrary, if we have too much cash and we are waiting for the perfect investment opportunity to come along, our cash earns a return of 0 until that opportunity is found. A return of 0 will also result in lower long-term returns. Balancing liquidity right is very important for our long-term success.

Actionable ideas

To start learning how to manage our liquidity, we need to understand the strategies professional investors use to buy financial assets and sell financial assets. In future lessons, we'll cover some basic strategies on how to start buying financial assets. 

A general good rule of thumb is to space out our buys. For example, if we plan to invest $1000 into AAPL shares, we should not buy $1000 worth of shares in one purchase.

 

Glossary

What is liquidity?

Liquidity is the ability to convert investment assets into cash.