What is liquidity in investments?
Liquidity is the ability of an asset to be quickly converted into cash without significant loss of value. Simply put, it's the ease with which you can sell your asset at any time for a reasonable price. The faster and cheaper this can be done, the higher the liquidity.
Imagine this scenario: you urgently need money. If you own shares in a large public company, for example, you can sell them on the stock exchange in a matter of seconds and have the funds in your account the very next day. However, if your money is invested in property or a stake in a private company, the sale could take weeks, months or sometimes even years.
In financial theory, liquidity is measured by several parameters. Firstly, there is time: how many days or hours does it take to sell the asset? Secondly, there are transaction costs, such as commissions, discounts on the market price and legal fees. Thirdly, there is market depth, which is how much of the asset can be sold without significantly affecting its price.
Liquidity is also closely linked to risk. Less liquid assets usually offer higher returns to compensate for their limited flexibility. This phenomenon is known as the 'liquidity premium': the investor agrees to tie up funds in exchange for potentially higher returns.
Examples of liquid assets
Liquid assets are financial instruments that can be quickly and cheaply converted into cash. They are essential for maintaining the financial flexibility of any portfolio, ranging from personal savings to large institutional funds.
The most common examples are the currency in your pocket and funds in a bank account. These are completely liquid as they are already cash, so there is no need to sell them. However, cash generates virtually no income, so holding too much of it is counterproductive.
Shares in public companies traded on major stock exchanges such as the NYSE, NASDAQ, London, and Warsaw Stock Exchanges are among the most popular liquid instruments. Trades are executed instantly at the market price, and settlements take place within one or two working days. Shares in companies such as Apple, Microsoft and Amazon, for example, can be sold on any trading day with minimal commissions.
Government bonds from developed countries are another classic liquid instrument. US Treasuries, German Bunds and UK Gilts have huge secondary markets where billions of dollars are traded daily. Investors can sell these bonds at virtually any time without significantly affecting the price.
Exchange-traded funds (ETFs) combine the diversification of investment funds with the liquidity of shares: they are traded on the stock exchange throughout the day, and their value reflects the price of a basket of assets. Gold and ETFs that track the S&P 500 index are two examples of instruments that combine broad diversification and liquidity.
Callable certificates of deposit, money market instruments, and short-term corporate notes also fall into this category, though they are more limited than shares. A transparent market with a multitude of buyers and sellers is a key characteristic of all liquid assets, as this guarantees a fair price at any time.
The advantages of liquid investments
Unquestionably, freedom is the primary benefit of liquid assets. You can react quickly to market changes without incurring penalties. If the market starts to fall, you can sell up. If a more profitable opportunity arises, you can move your funds to take advantage of it. This flexibility is invaluable in volatile markets.
Liquid assets provide a so-called 'safety net' — a reserve of funds that can be accessed in the event of unforeseen expenses or emergencies. Financial advisers recommend keeping three to six months' worth of living expenses readily available precisely because of this feature. For entrepreneurs and investors, this also means having 'dry powder' — capital ready to be deployed at the right moment.
Peace of mind is another important yet often underestimated benefit. You can make more logical choices about less liquid investments when you know that a portion of your assets is always available. Panic during a crisis can force investors to sell assets at the worst possible moment, but having a liquid reserve can help you avoid this trap.
From a portfolio management perspective, liquid assets make it easy to rebalance your investments. If one part of your portfolio has increased in value while another has decreased, you can reallocate funds without the need for complex legal procedures or lengthy negotiations.
Disadvantages
High liquidity typically comes at the cost of lower returns. The market effectively prices in this advantage; the easier it is to sell an asset, the lower its potential return. Deposits yield less than property, and investment-grade bonds offer a lower rate of return than venture capital investments with a similar time horizon.
Liquid assets are vulnerable to short-term volatility and market sentiment. For example, publicly traded shares can fall by 30–40% in a matter of weeks due to panic selling, even if the company’s original value has not changed. An impatient investor locks in losses that could have been avoided simply by waiting.
Another significant drawback is temptation. Easy access to funds can push an investor towards impulsive decisions, such as selling at the low point out of fear or buying at the high point out of greed. Discipline is therefore vital when dealing with liquid instruments, as the ability to act at any moment also carries the risk of making the wrong decision.
Lastly, regular trading in liquid assets may result in a higher tax burden in some jurisdictions, especially because short-term capital gains are subject to higher tax rates. This is yet another argument in favour of taking a strategic approach rather than engaging in chaotic trading.
Examples of illiquid assets
These are investments that cannot be quickly converted into cash without a significant loss of value or a lengthy sales process. They generally require greater patience, but offer the potential for higher returns and often serve as a hedge against market volatility.
Perhaps the most recognisable illiquid asset is property. Selling a flat, office building, or warehouse complex can take anywhere from a few weeks to several months, involving estate agents, solicitors, and notaries. In some countries, additional permission from government authorities is also required. At the same time, property values typically rise in the long term, making property attractive to conservative investors.
Shares in private companies are a key illiquid asset for venture capital investors. When buying shares in a startup, investors understand that these securities are not traded on a stock exchange. This means they can only be sold with the consent of other shareholders, on secondary markets such as Forge Global or Nasdaq Private Market, or by waiting for an IPO or M&A deal. This process can take anywhere from three to ten years or more.
Private equity is a category that includes company buyouts, investments in growing businesses ('growth equity') and funds with a clearly defined investment horizon. PE funds typically have a 10-year horizon, during which investors' funds are locked in. However, they aim to deliver returns that significantly exceed those on public markets.
Collectables and alternative assets, such as works of art, luxury goods, rare wines and classic cars, are also examples of extremely illiquid investments. The market for these assets is narrow, prices are opaque, and transaction costs can reach 20–25% of the transaction value. Nevertheless, a well-curated collection can generate substantial returns and serve as a status symbol.
The advantages of illiquid investments
The main advantage of illiquid assets is their potentially high returns. Venture capital funds that invest in early-stage companies typically target an annual return of between 20% and 30%, while successful individual transactions can generate a return of between 50 and 100 times the initial investment. Such returns are unattainable for most liquid instruments; the S&P 500 index has averaged an annual return of around 10% over the last 30 years.
Illiquid assets generally have a low correlation with public financial markets. When stock markets fall due to panic or a geopolitical crisis, the value of property or a stake in a private company tends to remain relatively stable — after all, its value is not being constantly updated on a public market. This makes them an excellent diversification tool, reducing the overall portfolio volatility.
The long-term nature of illiquid investments acts as a safeguard against investors themselves. Knowing that funds are 'locked in' for five to ten years means that you cannot succumb to market panic and sell at the worst possible moment. This discipline is built into the investment structure itself. Research shows that investors who cannot sell assets during a downturn often perform better than active traders.
Illiquid assets frequently provide additional rights and opportunities, such as voting rights on the board of directors, access to exclusive information and the chance to participate in strategic decision-making within the company. For a venture investor or private equity fund partner, it is not just a financial stake, but active participation in value creation.
Disadvantages
The most obvious disadvantage is the lack of flexibility. If you suddenly need funds, it will be particularly difficult to withdraw them from an illiquid asset without making a loss. In a crisis, you will either have to sell at a significant discount, take out a loan secured against the asset or simply wait. None of these options is ideal.
Illiquid assets are difficult to value fairly at any given moment. Unlike shares, whose prices are updated constantly, the value of property or a stake in a startup is subjective and may differ quite considerably from the actual market price at the time of sale. This makes portfolio planning and management challenging.
High-risk concentration is another problem. Investing a bulky sum in a single illiquid asset (for example, a specific startup or flat) makes you heavily dependent on the success of that particular investment. If the startup goes bankrupt or the property market in that area collapses, you will suffer severe losses. Diversifying in illiquid assets is technically more complex and requires more capital.
Finally, illiquid investments involve higher operational expenses and legal complexity. Opening an account with a venture capital fund, buying a stake in a private company, or completing a property transaction all require legal support, time, and money. If they are not considered during planning, transaction costs can sharply reduce the final return.
A comparison of liquid and illiquid investments
To better understand the differences between these two categories of assets, let’s examine them in terms of the key parameters that matter to investors.
In terms of exit time, liquid assets allow funds to be withdrawn within one or two days (shares and ETFs), or even instantly (cash). However, illiquid assets take months to sell (real estate) or even years (private equity fund shares and venture capital investments).
In terms of potential returns, liquid instruments typically offer moderate but predictable returns. The annualised returns on index funds over a 10-year horizon are around 7–10%. In contrast, illiquid assets can yield significantly more — top-tier venture capital funds show an IRR of 20–30%, while individual deals can be even more lucrative.
Speaking of risks, liquid assets are subject to market volatility, but this is transparent and visible in real time. In contrast, illiquid assets carry 'hidden' risk: you cannot see daily fluctuations, and upon sale, you may discover that the actual value differs significantly from the expected value.
When it comes to accessibility, most liquid instruments are accessible to investors with small amounts of capital — a few hundred dollars is enough to buy shares or ETFs, for example. In contrast, investing in venture capital funds, private equity, or high-quality commercial property requires significantly more capital — typically between $100,000 and $1,000,000, or more for institutional funds.
And the final one, regulatory protection: public liquid markets are strictly regulated to ensure transparency and investor protection. In contrast, private markets are less transparent, so investors must rely primarily on their own due diligence and the quality of legal agreements.
How to build a balanced investment portfolio that considers liquidity?
A balanced investment portfolio is a strategic decision that considers your financial goals, investment horizon, risk tolerance and personal circumstances.
The first step is to determine your 'liquidity buffer'. This is the amount that should always be available to cover day-to-day expenses and emergencies. As a general rule of thumb, it is advisable to keep between three and six months' worth of living expenses in fully liquid form, such as cash or instant-access accounts. For entrepreneurs or people with an unstable income, this buffer may need to be larger.
The second step is to define the time horizon and objectives for the rest of your capital. If you are investing for retirement in 20 years, for example, you can afford to hold a significant proportion of illiquid assets. However, if you need funds in 3–5 years to buy property or grow your business, the balance should be shifted towards liquidity.
A classic allocation for a long-term, diversified portfolio might look like this: 20–30% in liquid reserves (e.g. cash, short-term bonds and money market instruments); 40–50% in liquid investments (e.g. shares, ETFs and public bonds); and 20–30% in illiquid investments (e.g. property, private equity and venture capital funds).
Accredited investors with $1 million or more in capital can allocate 25–35% of their portfolio to venture capital funds and private equity strategies. This level allows investors to earn a liquidity premium without endangering their financial stability. It is important to remember that only 'long-term' funds – those that will definitely not be needed in the coming years – should be invested in illiquid assets.
Regular portfolio reviews are essential. As your financial situation, goals, or market conditions change, the optimal balance between liquid and illiquid assets will also change. Rebalancing your portfolio once a year or whenever there are significant changes in your life will help ensure it remains strategically optimal.
Practical examples
To better understand how liquidity principles work in practice, let’s look at a few real-life scenarios.
Example 1:
A 32-year-old entrepreneur with a stable income from his own business wants to invest $200,000 for over ten years. The recommended allocation would be as follows:
- $20,000 for a liquidity reserve (cash and deposits).
- $100,000 for liquid assets (S&P 500 index ETFs and bonds).
- $80,000 for illiquid assets (a stake in a venture capital fund or a direct investment in a startup via a syndicate).
This allocation provides a secure 'safety net', market returns, and the opportunity to participate in venture growth.
Example 2:
A married couple in their fifties are preparing for retirement. Their time horizon is 10 years, and they prioritise stability. Their portfolio should therefore be more conservative: 30% in a liquid reserve (deposits and bonds); 50% in moderately liquid assets (dividend-paying shares and REITs); and 20% in illiquid assets (property for letting). This protects against the need to sell assets at an unfavourable time after retirement.
Risks associated with liquidity
Liquidity planning is critical for risk management. Failing to recognise or misjudging liquidity can lead to significant financial losses, even within a generally sound portfolio.
Liquidity risk refers to the probability that an investor will be unable to sell an asset at a fair price when needed. For instance, during market crises like 2008–2009, assets such as structured credit products that were previously thought to be relatively liquid suddenly became inflexible because there were no buyers. Investors without sufficient liquid reserves were forced to sell good assets at a low price.
There is also a risk of concentration in illiquid assets. If too large a proportion of a portfolio is invested in them, you become vulnerable to a 'forced sale' — selling assets on unfavourable terms to raise funds. A classic example is an entrepreneur whose wealth is tied up in their own business. Technically, the businessman may be very wealthy, but if the company runs into difficulties and there is no cash, the owner may find themselves in a difficult position.
Misjudging liquidity is another danger. Some assets appear more liquid than they actually are. For instance, shares in small companies with low trading volumes may be formally liquid (traded on a stock exchange), but selling a large block of these shares will lead to a significant price drop. Investors often underestimate this 'market impact'.
Over time, there is a chance that liquidity conditions will alter. For example, an asset that was liquid five years ago may have become illiquid today due to changes in the market environment, regulatory conditions, or the competitive landscape. Monitoring each asset's liquidity regularly is crucial.
A particular hazard in the VC business is capital becoming ‘frozen’ without adequate compensation. If a startup neither progresses nor regresses — if it remains in a so-called 'zombie state' — your funds may be tied up indefinitely with no prospect of recovery. Thoroughly vetting the team, the market, and the exit strategy before investment is the only reliable safeguard against this risk.
Conclusions and recommendations
There is no single 'correct' level of liquidity that suits everyone. The optimal portfolio structure depends on personal goals, financial situation, investment horizon, and psychological comfort level. A young investor with a long-term outlook can afford to hold a larger proportion of illiquid assets. Those approaching retirement or with an irregular income need greater liquidity.
Always maintain a liquidity buffer. Regardless of the size of your capital or the aggressiveness of your strategy, it is essential to have a reserve equivalent to 3–6 months' worth of expenses in fully liquid form. This protects you against unforeseen circumstances and guarantees that you will never be forced to sell good assets at an unfavourable time.
Use illiquid assets to boost returns, but only with 'long-term' funds. Investments in venture capital funds, private equity or property should only be made if you will not need access to these funds for the entire investment period, which can be anywhere from five to ten years or more.
Review the liquidity of your portfolio regularly. Markets change, your financial situation changes, and the optimal balance between liquid and illiquid assets must also change. Reviewing your portfolio annually or every six months will help you to remain in the right strategic position.
Do not overestimate liquidity. Some assets appear liquid, but in a crisis, the market for them can disappear. Always stress-test your portfolio. Ask yourself: what would happen if you needed 30% of your capital within 30 days? Would you be able to access it without making significant losses?
Finally, here is the most important piece of advice: a savvy investor always considers liquidity in advance. Venture capitalists, successful fund managers and experienced private investors are united by one principle: they structure their portfolios so that they never find themselves short of liquidity. It is this very foresight that distinguishes true investment success from mere financial luck.
