Liquidity Risk 101

Understanding Liquidity Risk and Your Investments

Liquidity Risk and Your Investments
Liquidity risk involves the ability to turn your investments into liquid cash in a short period of time. Investors that don't learn to manage their liquidity risk could face bankruptcy even if they make a lot of money and have millions in net worth. John Holcroft/SuperStock/Getty Images

As a new investor, you might come across a concept known as liquidity risk. It is important you understand what liquidity risk is and why it is important because it could pose a significant threat to your financial well-being unless you protect against it. Although I've explained how some investors strive to pay off their home mortgage debt early but find themselves bankrupted due to the liquidity crunch they created for their household, I wanted to stop to talk about the specifics of how liquidity risk can attack you in other, unexpected ways.

Liquidity Risk - The Short Version

In the simplest terms, liquidity risk refers to the risk that an investment won't have an active buyer or seller when you are ready to buy or sell it. This means you will be stuck holding the investment at a time when you need cash. In extreme cases, liquidity risk can cause you to take huge losses because you have to mark down your property at fire sale prices to attract buyers.

One of the reasons for the losses suffered by financial firms during the Great Recession was the fact that these companies owned illiquid securities. When they found themselves without enough cash to pay the day-to-day bills, they went to sell these assets but discovered that the market had dried up completely. As a result, they had to sell at any price they could get - sometimes as low as a few pennies on the dollar!

The most famous case is Lehman Brothers, which was financed with too much short-term money.

The management foolishly used this short-term money to buy long-term investments that weren't liquid - or rather, assets that became illiquid after the meltdown. When the short-term money was withdrawn, the firm couldn't come up with the cash because they couldn't sell the long-term, illiquid securities fast enough to meet obligations.

The stockholders were nearly wiped out despite the fact that Lehman was profitable and had a multi-billion dollar net worth.

On the upside, there is opportunity with liquidity risk because other companies and investors that were flush with cash were able to buy distressed assets. Some of these "vulture" investors made a killing because they had balance sheets that could support holding non-liquid investments for long periods of time.

To compensate for liquidity risks, investors often demand a higher rate of return on money invested in illiquid assets. That is, a small business can't be easily sold in most cases so investors are likely to demand a higher rate of return for investing in shares of it than they would a highly liquid blue chip stock. Likewise, investors require a much smaller return for parking money in the bank.

Liquidity Risk - The Long Version

There are several different types of liquidity risk but I'm only going to teach you about the three major ones that are likely to afflict regular investors.

  • Liquidity Risk #1 - Bid/Offer Spread Widening - When an emergency hits the market or an individual investment, you may see the bid and ask spread blow apart so that the market maker has a difficult time matching up buyers and sellers. That is, your shares of Company XYZ stock may have a current market price of $20 but the bid may have fallen to $14 so you can't actually get the $20 you want! You often see very large ask / big spreads in thinly traded stocks and bonds, whereas huge, liquid blue chip stocks often have spreads as low as a penny or two.
  • Liquidity Risk #2 - Inability to Meet Cash Obligations When Payment Is Due - This is the investment equivalent of defaulting on a debt. If a company has $100 million in bonds that reach maturity, it is expected to pay off the entire $100 million balance by the maturity date. Most of the time, businesses refinance this debt. But what happens if the debt markets aren't working, like during the Great Recession when the credit crunch made it impossible to borrow money? In that case, if the company couldn't come up with the whole $100 million, it could be hauled into bankruptcy court even if it is highly profitable. You would find yourself locked into what could be years of legal workouts due to the firm mismanaging its liquidity risk.
  • Liquidity Risk #3 - Inability to Meet Funding Needs at an Affordable Price - This is when it is impossible for a company or other investment to raise enough money to function properly and meet its needs at a price that is economical. Wal-Mart Stores, Inc., for example, is one of the biggest and most profitable companies on the planet. It has tens of billions of dollars in debt in order to optimize the company's capitalization structure. If the markets went haywire tomorrow and Wal-Mart could no longer borrow at 6% and investors instead demanded 30%, it would make no sense for the company to issue bonds. In effect, the market's liquidity would have dried up completely and the stockholders of Wal-Mart would have to worry about the company coming up with enough cash to wipe out all of its debt.

    Protecting Yourself Again Liquidity Risk

    There are several ways you can help protect yourself from liquidity risk. These include:

    • Never buy long-term investments that are illiquid unless you can afford to hold them through terrible recessions and job loss. If you might need cash in six months, don't buy 5-year certificate of deposits or an apartment building.
    • Remember that your total debt is less important as the amount of excess cash you have after making your debt payments each month. Fixed payments of $5,000 per month are overwhelming to someone with $6,000 per month in take-home pay. The same payments are a rounding error to someone making $300,000 per month. All else being equal, the bigger the cushion between the cash you earn each month and the cash you pay out, the less the chance you get caught in a liquidity risk crisis.
    • Avoid investing in companies that are facing potential liquidity risk. Are there any big debt refinancing plans that could risk the company's well-being? Does the company have a solid balance sheet with long-term funding sources, such as shareholder equity instead of short-term deposits? If you don't understand what this means, you should probably stick to low-cost, widely diversified index funds.