Understanding Liquidity Risk: What Self-Directed Investors Should Consider

In the context of investing, liquidity risk is the possibility that you may not be able to buy or sell an investment quickly enough or at a fair price when you want to.

Liquid markets, such as money markets and treasuries, can generally be bought or sold with minimal price impact. Illiquid markets, on the other hand, may have fewer participants and less frequent trading, which can make it harder to exit a position without accepting a lower price.

Even for products that generally seem liquid, like exchange-traded funds, liquidity can vary based on several factors, including the liquidity of the underlying assets, trading volume of the ETF itself, and the presence of active market makers. One important mechanism that supports ETF liquidity is the creation and redemption process. This allows authorized participants to add or remove shares from the market by exchanging them for the underlying securities. As a result, even if an ETF doesn’t trade frequently, it may still be possible to buy or sell shares at prices close to the value of its underlying assets, helping maintain liquidity.

Several factors can affect how easily an investment may be bought or sold.

1. Market Volume and Depth

Securities that trade frequently and in high volume — such as large-cap stocks or treasury bonds — tend to be more liquid.

2. Asset Class Characteristics

Typically, cash and money market instruments are the most liquid because they can be quickly and easily turned into cash with little or no loss. Equities, especially those of well-known companies, are generally considered moderately liquid because they can be sold fairly easily, but not as instantly or reliably as cash or money market instruments.

Assets such as real estate, private placements, or some fixed income securities may be considered illiquid due to infrequent trading and limited market participants.

Liquidity risk may be especially pronounced in fixed income markets, which often operate over-the-counter rather than on centralized exchanges. Some bonds may be difficult to price or sell, particularly if they are lower-rated, long-dated, or from smaller issuers.

3. Market Conditions

During periods of economic uncertainty or financial stress, liquidity across certain asset classes can decline. Investors may gravitate toward cash and other low-risk instruments, reducing demand for riskier or less liquid assets.

4. Bid-Ask Spread

A wider bid-ask spread — the difference between what buyers are willing to pay and what sellers are asking — can be an indicator of lower liquidity. When urgency is involved, investors may need to sell closer to the bid price, which can reduce returns.

Investors can occasionally be compensated for taking on higher levels of risk, and liquidity risk is no exception. Illiquid assets may offer the potential for higher returns to account for the reduced flexibility, longer holding periods, and added uncertainty that come with limited market access. Because these assets may take longer to sell or may not be easily priced on a daily basis, investors typically demand a ‘liquidity premium’—an extra return to justify the inconvenience and additional risk of being unable to exit quickly. Examples of investments that may carry liquidity risk include:

Examples of investments that may carry liquidity risk include:

• Private equity or venture capital
• Real estate investments
• Certain corporate bonds
• Small-cap or micro-cap stocks
• Alternative investments.

While these types of investments may offer return potential, they can also be more difficult to sell in a timely manner, particularly during market downturns. This is because they often lack an active secondary market, have fewer potential buyers, or involve complex sale processes. During periods of stress, buyers may become even more scarce or demand steeper discounts to take on the risk. As a result, investors may experience delayed access to their funds or may be forced to sell at significantly lower prices than anticipated in order to complete a transaction.

This may lead to delayed access to funds or the need to sell at a lower price than expected.

For self-directed investors, managing liquidity risk involves thoughtful planning and awareness of how different assets may behave under various market conditions.

Diversify Your Liquidity Profile: A balanced portfolio may include a mix of liquid and less-liquid assets. This can help reduce the likelihood of needing to sell illiquid investments during periods of market stress.

Align with Your Time Horizon: If you are investing for a long-term goal and do not anticipate needing immediate access to funds, you may be more comfortable including some less-liquid holdings. If your goal is short-term or uncertain, prioritizing more liquid assets may help maintain flexibility.

Conduct Due Diligence: Before investing in any security, especially one that is not frequently traded, it may be helpful to understand how often the asset trades, the typical bid-ask spread and the ease or difficulty of exiting the position under normal and adverse conditions.

Maintain an Emergency Reserve: Keeping a portion of your overall assets in a highly liquid vehicle, such as a high-interest savings account or money market fund, may help to provide access to cash when needed. This may help prevent the need to sell long-term investments at an unfavorable time.

By understanding what liquidity risk is and how it may affect your portfolio, you can take steps to manage it proactively. For self-directed investors, considering liquidity alongside other factors such as risk tolerance, investment horizon, and diversification may lead to better-informed decisions, especially during uncertain markets.

If you are unsure how liquidity risk may affect your current strategy, reviewing your portfolio holdings and considering how easily they could be accessed or sold in different scenarios may be a worthwhile step.