The liquidity of an asset is its ability to be converted into cash. Therefore, illiquidity is the opposite of liquidity. Some assets are classified as liquid assets, whereas others are illiquid assets. Thus, liquid assets are more valuable as they can be easily converted to cash if required. Illiquid assets can pose difficulty in such situations.
Sometimes illiquid assets have high value, but converting them into cash may take a long time. A suitable example of this is real estate. Although it is one of the most favoured modes of investment, its liquidity is comparatively lesser compared to other assets like equity listed on an active stock exchange.
This article explains illiquidity, illiquid stocks, the meaning and their examples, and how to identify and buy illiquid stocks.
What is illiquid stock?
Illiquid stocks are high-risk stocks that cannot be sold without a substantial loss in value. Illiquid stocks or assets do not have ready buyers. As a result, there is a difference in the asking price by the seller and the price offered by the buyers. This gap seems to be greater than the one seen in an orderly market where daily trading occurs.
There is a lack of ready buyers for the asset, known as depth of market, due to which the owner experiences loss, especially if they want to sell the stocks quickly. Illiquid assets are hence high-risk assets and high-cost assets for an investor. It is not easy to sell them for cash as they are expensive to maintain and tend to be volatile.
Examples of Liquid and Illiquid assets
Illiquid assets include real estate like houses, commercial spaces or industrial sites, cars, antiques, private company interests, and debt instruments. Some collectables and art pieces are illiquid assets too. Over-the-counter (OTC) trading stocks are less liquid than those traded on bourses. These stocks have lesser buyers even though they have a high value.
In the context of a business, illiquidity refers to a company that does not have the cash flows necessary to make required debt payments, despite having assets. During bankruptcy, the company may have to sell its capital assets like land, machinery, and production equipment. Although they are valuable, such assets cannot be sold easily. The company may be forced to make a distress or fire sale to meet liquidity requirements. The assets get a lower price than their value in a distress sale.
On the other end of the spectrum, securities like stocks, ETFs, mutual funds, bonds, and commodities listed on the stock exchanges are the most easily liquefiable assets. They can be sold and purchased instantly at the market price at regular market hours. Precious metals also offer a fair price for their value at regular market hours.
In between these two extremes are items whose liquidity may change over time. Depending on external market influences, the price may change. For example, collectables whose prices fluctuate in the market considerably due to changes in their popularity.
How to identify illiquid stocks?
If any of the following signs apply to stock, they can be classified as illiquid stocks. It is important to study the market at the same time.
1. The stock is not traded in high volumes every day
2. The stock hits low values regularly.
3. There is a considerable difference in the bid and ask prices.
4. Institutional investors don’t show interest in the stock.
5. They are difficult to trade compared to liquid stocks.
6. If the stock loses significant value after it is sold.
How do I buy illiquid stocks?
One can buy illiquid stocks using the following precautions to avoid significant losses.
1. Stocks are bought on a limit order set by the investor. The broker is instructed to buy or sell within the maximum and minimum limits.
2. The stocks are bought in fixed lots so that big chunks are not allotted.
3. The commissions should not exceed 1%.
4. The values of the stocks should be fixed. Bidding is not allowed.
5. Stocks are easily liquifiable for small investors.
There is a possibility of illiquid stocks performing well over the long term. Likewise, there is risk associated with them too. It is thus essential to have a strategy in place for investing in illiquid stocks, depending on the investor’s risk appetite and long-term plan.
A prudent investor will identify illiquid stocks that have a good chance of gaining in the long term. They will do the required analysis before investing in them and finance a small quantum of their investment portfolio, the loss from which can be sustained. Calculated risks can often prove to be beneficial.