Liquidity is defined in the Dictionary of Finance and Investment Terms as “the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price.”
In layman’s terms it means being able to get to your money quickly and without a major loss. Liquid assets are things like checking accounts and money market funds. They can also include mutual funds and stocks in large companies that trade on a major stock exchange, although in times of severe financial stress even these may see major price swings.
But there are lots of things people own that are not liquid. The typical family’s home is a large part of their wealth. Homes are not liquid; they can’t be sold quickly and converted to cash in times of need. What a home can be sold for is a guess; something that millions of people learned when the housing bubble burst in 2008. Families found that the value of their home was tens, even hundreds of thousands of dollars less than their mortgage.
Besides a home, many stocks are not liquid. Shares in small companies with a few shares outstanding may not be liquid. Even the very wealthy are finding out that the liquidity trap can turn them from billionaires to paupers in short order. Forbes Magazine listed Elizabeth Holmes, the founder of Theranos, as America’s richest self-made woman last year with a fortune estimated at $4.5 billion. The most recent listing gave her net worth at zero. The reason for this is fairly simple. Her net worth was based on the value of one stock: Theranos. The stock was not publicly traded and if she had tried to sell some of it the share price would have plummeted because it would show a lack of confidence in the future of the company.
So when Theranos ran into serious problems Holmes could not get out and her fortune literally disappeared into thin air.
The average person can avoid the liquidity trap by following a few simple rules.
- Do not put too much of your personal wealth in things – like homes – that can’t be easily sold.
- Do not put too much of your personal wealth in one stock. You do not want your net worth to evaporate because of poor decisions by corporate management.
- Smart investors spread their financial assets widely. Realizing that they cannot accurately predict the future, they own stocks and bonds, domestic and foreign. If they don’t have the means to diversify using individual stocks and bonds they use mutual funds or ETFs.
- Get an advisor. Most smart people use professionals when they need medical, legal or financial advice.
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