Liquidity Risk — The Risk of Not Being Able to Sell When You Want
'Return' is a story for when you can sell. If buyers disappear, even a great asset can't be sold at a fair price. This is liquidity risk.
What Is Liquidity Risk
Liquidity means 'how quickly, and at a fair price, an asset can be converted into cash.' Liquidity risk is the risk that this becomes difficult.
For example, a large blue-chip stock can be sold in seconds, so it has high liquidity. Real estate, on the other hand, can take months to find a buyer, so it has low liquidity.
Liquidity risk appears in two faces. (1) The case where it can't be sold at all. (2) The case where it does sell, but you have to cut the price sharply below fair value.
Even if the book valuation is high, if you can't actually sell at that price, that return is just 'a number on paper.'
Liquidity Differs by Asset
Assets sit on a liquidity spectrum.
High liquidity: deposits and MMFs, large listed stocks, major-country government bonds, large ETFs. You can sell almost immediately at a fair price when you want.
Medium: small-cap stocks, corporate bonds, some REITs.
Low liquidity: real estate, unlisted stocks (private, venture), collectibles, some alternative investments.
The lower an asset's liquidity, the wider the bid-ask spread (the gap between buy and sell prices), so a loss occurs just from buying and selling. That is why, the more a product touts 'high returns,' the more you must first weigh whether you can actually sell it when you want to.
Real estate and unlisted assets have low liquidity, so selling takes a long time and the bid-ask spread is wide. Differences in liquidity are directly tied to the trading costs covered in the bid-ask spread piece.
In a Crisis, Liquidity Disappears
The scariest moment for liquidity risk is a crisis. Even assets that usually sell well see buyers disappear all at once when the market falls into fear.
If everyone tries to sell at once, prices plunge, and even cutting the price sharply, buyers become hard to find. Investors using leverage are then driven to margin calls and forced to sell at fire-sale prices, which in turn drags prices down further in a vicious cycle.
In other words, liquidity risk combines with other risks (leverage, systemic risk) to amplify a crisis. You must remember that 'normal-time liquidity' and 'crisis liquidity' are entirely different.
Frequently Asked Questions
Q. Should I unconditionally avoid low-liquidity assets?
Not unconditionally. Low-liquidity assets like real estate and private investments have their own roles and expected returns. That said, given that 'you can't sell right when you want to' and that you may have to dispose of them at fire-sale prices when you urgently need cash, it is safer to approach them with spare money — not money you'll need soon.
Q. Why can products that tout high returns be risky?
Among products that offer high returns, many have low liquidity, making it hard to redeem or sell when you want. Even if the valuation-based return is high, it means nothing if you can't actually sell at that price, and in a crisis redemptions are sometimes suspended. That is why checking 'when and how you can sell' is as important as 'how much you earn.'
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