What is Liquidity?
Liquidity in the financial sense refers to how easily we can convert assets into cash. Of all the many different types of assets, some are more “liquid” than others.
Cash is considered to be the most liquid asset. This is because you can buy something with cash more easily than you could with other assets such as your TV or jewellery, for example. Conversely, if you were selling something you owned, you probably just want cash for it more than you would want a used TV or someone else’s jewellery.
In a more general financial market context, the more liquid an asset is, the easier it would be to buy or sell it in a financial market. Blue chip stocks and many government bonds are examples of highly liquid financial assets, because you can convert them into cash within a matter of days given there are many buyers and sellers of these assets across the world. This is in contrast to real estate, for example, which would take weeks or months to convert into cash – this is an illiquid financial asset.
Looking within the stock market, we can observe that some stocks are more liquid than others. Let’s look at two of the main drivers of stock liquidity:
• The larger a company’s market cap, the more liquid its stock tends to be. This is primarily due to two reasons. First, large companies tend to be part of large indices (S&P 500, FTSE 100, etc) – and many investors buy and sell ETFs which track these large indices, which means there is a more regular demand / supply of the underlying companies which make up these large indices. Second, many large institutional investors and fund managers are restricted to buying liquid stocks – making the market for larger companies more active than the market for smaller companies as many large investors do not trade the smaller stocks.
• The larger a company’s free float, the more liquid its stock will be. Free float refers to the shares that are owned by institutional and retail investors which are potentially available for sale / purchase on a daily basis. As an example, if Company A had 100 shares outstanding with a price of $10, but the founder owned 90 of them, it would be safe to assume that only up to 10 shares would be available for sale / purchase on any given day as the founder would not typically engage in frequent buying / selling of the company’s stock. Company A would have a 10% free float in this example – not many shares would be traded on a daily basis – maybe 1 or 2 on average! Compare this with Company B, which also has 100 shares outstanding and a price of $10, but all of which are owned by institutional and retail investors who trade them on a daily basis. In this case, you might have around 10 – 20 shares being traded on average every day – clearly a more liquid stock than that of Company A.
Why should you care?
Liquidity is very important from an investor’s perspective because it will drive how quickly you are able to buy / sell a stock or financial asset, and whether you will receive a fair price for it in the market.
Furthermore, highly liquid stocks and financial assets also tend to have incremental price movements, which give us the relatively smooth price charts that we are used to seeing when looking at Facebook, Amazon, Apple or other large company shares for example. This is in contrast to smaller companies which are less actively traded on the stock market and can have less smooth price movements – these price charts can sometimes look like stairs, with prices suddenly dropping lower or jumping higher in large increments. In this sense, stocks can also be more desirable to own due to the relative price stability they have when compared to their illiquid counterparts.
The original article can be found here.