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.
Being able to quickly convert investments to cash gives us many advantages.
- Allows us to seize opportunities on great investments faster
- Allows us to better manage our risk in a market crash
- 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?
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.
Illiquid assets have small markets and limited supply and demand. These assets take a long time to sell and prices and fluctuate wildly.
We can bucket lists of available assets by the size of their markets and liquidity.
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.
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.
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.
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.