What is Liquidity?

As part of our educational series we want to acquaint our readers with terms that are in common use in investing but may not be completely understood by the public.  One of those terms is “liquidity.”  The Dictionary of Finance and Investment Terms says liquidity “is the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price.”  Stocks in large blue-chip stocks like General Electric, Microsoft or Apple are liquid because they are actively traded in large volumes and therefore the price of the stocks will not be affected by a few buy or sell orders.

However, shares in small companies with relatively few shares are not considered liquid because a few large orders can move the price of the stock up or down sharply.

A house is another example of an illiquid asset because it can’t be sold quickly, its price can fluctuate widely because it’s not traded regularly on an exchange and the price is set by bidding between one or a few buyers and a single seller.

Liquidity also refers to the ability to convert to cash quickly.  Examples are money market mutual funds, checking accounts, bank deposits or treasury bills.