Definition and Example of Illiquid Assets
An illiquid asset is an asset that takes time to convert into cash quickly without incurring significant expense. Illiquid assets have several advantages, as we’ll review, but they are not ideal for emergency expenses because they generally can’t be used immediately. Liquidity refers to how efficiently an asset can be bought and sold on the secondary market. A liquid asset is an asset with plenty of potential buyers that can be quickly sold without incurring substantial costs. Physical cash itself is a liquid asset, as are funds in a money market account or checking or savings account. An illiquid asset has a higher liquidity risk, or the risk that an investor won’t find a buyer for their asset, than a more liquid asset. You may wind up holding an illiquid asset for longer than you want, or you could be forced to sell it at a steep discount. An asset can also be considered illiquid if there are high costs associated with selling it. For example, a certificate of deposit (CD) that charges an early withdrawal penalty is an illiquid asset. If you haven’t reached retirement age, your 401(k) isn’t a liquid asset because you’ll typically pay income tax plus a 10% penalty on your withdrawals. Real estate is one of the most common types of illiquid assets. Home equity accounts for nearly 70% of household net worth in the U.S. But if you want to tap home equity, it can take months. You’ll typically have to list the home, find a buyer, negotiate the price, complete inspections and closing, and more. Real estate is an illiquid asset because of the time and costs required to sell it.
How Illiquid Assets Work
Common factors that contribute to an asset’s illiquidity include:
Transaction costs: Higher fixed costs associated with buying and selling an asset result in lower liquidity. A large-cap stock that you can easily buy and sell with an online brokerage account is highly liquid. But if an investment is complex enough to require lawyers and brokers, such as buying property, it’s likely to be illiquid. Lack of demand: When you want to sell an asset, there may not be an available buyer, which makes the asset difficult to sell quickly. Private information: A seller may have information suggesting the asset will perform poorly in the future that the buyer isn’t privy to. Due to the risk of unknown information, a buyer may offer a price below the asset’s market value. No centralized market: If there’s no centralized market for an asset, you may need to negotiate prices and conduct due diligence. A lack of a centralized market often results in wide bid-ask spreads, meaning buyers are willing to pay less than what sellers are willing to sell for.
Penny stocks are another example of an illiquid asset. They typically trade on over-the-counter exchanges, rather than on a major stock exchange like the New York Stock Exchange (NYSE) or NASDAQ. A penny stock typically has a low trading volume compared to a stock issued by a larger company, which means you may have trouble selling a penny stock at the time and price you want. Illiquid assets can also be valuable personal possessions. Some people invest in collectibles like art, baseball cards, or antique cars. These are all considered illiquid assets because there’s no centralized market of ready buyers.
What It Means for Individual Investors
Investors may buy illiquid assets because they have the potential to provide reliable returns for lower risk, but they are not ideal to cover emergency expenses. Financial advisors recommend against investing your entire net worth in illiquid assets. Maintaining some liquidity will give you easy access to cash to cover emergency expenses like car repairs or hospital bills. Maintaining liquidity helps you avoid selling illiquid assets at a loss or taking on debt to pay your bills if you’re unable to sell the assets right away. Widely traded stocks, mutual funds, and exchange-traded funds (ETFs) are all considered liquid assets. However, they’re not completely liquid because they do bear market risk and it does take some time to sell them as well (though usually only a matter of days). You could incur a significant loss, for example, if you need to sell stocks when the stock market is down. A good rule of thumb is to keep three to six months’ worth of living expenses in an emergency fund with liquid assets. A savings account is considered liquid because you can access your money when you want without penalty. Though they’re slightly less liquid than a savings account, you can also keep your emergency fund in other liquid assets like short-term CDs, Treasury bills, or money market mutual funds.
