When it comes to investing, liquidity plays a significant role in measuring the types of investments that are right for your portfolio. Today we will be exploring the differences between illiquid versus liquid investments and how this plays into your risk-return ratio as an investor!
What Is an Illiquid Investment?
Liquidity describes the ability to trade your asset in for cash. The term illiquid means an asset cannot be quickly converted into cash. Illiquid assets are recognized to take a lengthier period of time before there is a significant gain in their value.
A primary example of illiquid investment would be real estate. Illiquidity in real estate means that once the investor invests in a property, they have to wait for a certain period before receiving their return on investment. In many real estate syndication projects, this timeline can change depending on the market conditions.
This can mean that although a project is expected to be held for 5 years, it could end up delivering substantial returns in a year, which has been the case in previous real estate syndications here at Disrupt Equity. Although some real estate projects take 3-5 years, the increased stability and returns prove to be incredibly attractive to many investors, especially when you factor in the cash flow potential throughout the hold time of the asset.
Along with real estate, there are many other examples of Illquid assets that can prove to be very lucrative for investors.
Examples Of Illiquid Assets
A few examples of illiquid investment assets would be:
- Real estate
- Private Equity and Venture Capital
- Private Placement Loans Issuances
- Intangible Assets
- Collectible Cars
What Are Liquid Investments?
A liquid investment is any investment with a short-term maturity that can easily be converted into cash without having a significant impact on its value.
Investments are not considered to be liquid when it takes a significant amount of time to convert them into cash or if the act of selling them reduces their value.
Examples of Liquid Investments
Investments with more liquidity include:
- Stocks and Marketable Securities
- Money Market Funds
- Exchange-traded funds (ETFs)
- Mutual Funds
- Short-Term Certificate of Deposits
- Short-Term U.S. Government Bonds
Pros of Liquid Investments
The greatest advantage associated with liquid investments is the investment is easily convertible into cash. This allows investors to be flexible when other lucrative investment opportunities arise, reducing an investor’s opportunity cost.
Liquid investments also reduce an investor’s risk in emergency situations. In the case an investor needs immediate capital, liquid investments can allow an investor to cash out quicker than possible with illiquid investments that have a longer hold time. Liquid investments can protect an investor from sourcing unnecessary debt in such times of need.
Cons of Liquid Investments
Although liquid investments may reduce an investor’s risk, many liquid investment opportunities can limit an investor’s potential for achieving greater returns. Real estate and private equity, for example, have consistently provided investors above-market returns. For an investor looking for higher returns, the longer termer illiquid investment may be the path to meet their financial goals.
Pros of Illiquid Investments
Illiquidity in real estate means that the property cannot readily be disposed of, as it takes time for the property to show some increment in its market value. Though illiquidity may appear to create a negative image in an investor’s mind, it can be immensely beneficial in terms of return on investment (ROI). Certain illiquid investments have more value and safety than liquid investments can provide.
An example of this would be land; Although the price of land may fluctuate depending on marketing conditions, this asset will never deplete in value.
From an overall portfolio perspective, the allocation to real estate, at the least, should help reduce portfolio volatility.
Lastly, illiquid assets could offer diversification from more liquid, publicly traded assets. This is through the allocation of capital across various asset classes. It may help balance the portfolio and ensure that your money is not tied up in one market or asset class.
Cons Of Illiquid Investments
If we were to point out the cons of Illiquid investments, they might be summarized as the following. An illiquid investment cannot easily be converted to cash, especially if there is an urgent need to do so.
Additionally, the opportunity costs associated with investing in illiquid assets are quite high as investor must invest money into such an asset for a longer duration than would be the case with liquid assets.