Investing - Definitions 102

Last issue we discussed why you invest and defined assets and liabilities (click here to read). Another important aspect of investing is understanding the liquidity of the asset the investor chooses to invest in. Let's define what liquidity is and why it is important.

Liquidity simply means how easy is it to sell an asset and turn it into usable cash. Some investments are highly liquid, which means you can turn a large investment into a large amount of cash in a short amount of time. Generally, investments in publicly traded companies (i.e., Microsoft, Coca-Cola, John Deere) are highly liquid. If you wanted to sell one million dollars of Microsoft stock, it would be very easy and quick - literally in a matter of seconds.

Other assets are highly illiquid, which means it takes much longer and requires more effort to convert the investment into cash. Real estate is a prime example. If you wanted to sell a rental house, it takes time to do the necessary documentation to protect all parties before you have the cash from the sale. In addition, illiquid assets can have larger price fluctuations as the price of the asset adjusts to find a buyer. At times, these fluctuations can be very large and severely hurt the investor if no one wants to buy what they are selling.

Understanding liquidity is important for your planning purposes and making sure you provide ample time to sell an asset. No one likes to be hurried into a sale to generate cash for an expense. A well-diversified portfolio can have both liquid and illiquid assets, but make sure you fully understand the liquidity for all your investments in order to plan for cash flow needs adequately and profitably.