'Liquidity risk' probably sounds like something technical that most investors don’t need to worry about. In reality, however it is something that is likely to affect everybody at some point.
The liquidity of an investment refers to how quickly it can be sold. Shares in Apple or Amazon are highly liquid because hundreds of thousands of them are bought and sold every day.
A sheep farm in the Karoo, on the other hand, is a lot less liquid. There aren't as many of them, for a start, but there also aren’t thousands of people lining up on a daily basis to get their hands on one. If you own one and want to sell it, it will therefore take a lot longer to find a buyer.
This is important to investors because if something cannot be sold quickly, it becomes very difficult to prevent or minimise a loss. If you own shares in Apple, even if they drop sharply, you should have little trouble selling them. You can therefore manage how much of a hit you actually take.
On the other hand, if the bottom falls out of the sheep farm market in the Karoo, disposing of that property at a good price could be almost impossible.
What is important for any investor is to remember that any asset is only worth what you can sell it for. And if you have to sell something in a hurry, if it is not liquid, you may find yourself getting a lot less for it than you expected.
A good example is property. Your home might be valued at R2 million today, but if there is a downturn and you need to sell, you are unlikely to get that much.
This is what happens with distressed property sales. People are so desperate to liquidate their houses that they are willing to take much less they are actually worth.
But liquidity risk can go even further. If an asset is only worth what you can sell it for, it follows that if you can't sell it at all, it is worth nothing.
This is a risk that many people putting their money into 'alternative', unregulated investment schemes fail to appreciate.
In a unit trust, you have guaranteed liquidity. If you ever want to buy into or sell out of one of these funds you will always be able to do so. That is how they are structured.
But lots of other so-called ‘investment opportunities’ don’t offer the same guarantees. There are plenty of examples.
‘Collectible coins’ seem to be a fad that comes and goes. Dealers sell them as supposedly great investment opportunities, but without the guarantee that they will buy them back. And if you can't find a buyer for the coin that you paid thousands of rand for, then what is its actual value?
Other examples include the likes of people selling ‘baskets’ of rare minerals that they store on behalf of investors. They even give regular price updates. However, how those prices are determined is anyone’s guess because when investors want to sell their baskets, they invariably find that there isn’t anyone who wants to buy them.
That means that they are left holding assets which are, effectively, worthless. If no one will buy them, they have no value.
This is something that investors should watch out for when considering 'investment opportunities' that are out of the ordinary. If they involve buying an asset in the belief that its value will increase over time, always remember that, in the end, that value can only actually be realised if there is someone on the other end to sell it to.
To discuss investment risks, speak to a professional.
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