Liquidity means the ability to turn an asset into cash. Having liquidity gives you the feeling of control, but liquidity provides both real control and the illusion of control. The financial reason for wanting liquidity from what are intended to be dollars left untouched until some future date, is the ability to cope with or avoid potential risk. If you have an unexpected financial emergency, being able to sell or transform an asset quickly to get dollars in your hands is real control. This is generally what is thought of when one thinks about their asset being liquid, but liquidity isn’t that simple.
Does liquidity also mean getting the money without a cost? If so, then certificates of deposit within their penalty period could be viewed as illiquid. Indeed, even money market accounts could be viewed as illiquid since federal law limits free withdrawals to not more than six per month. Typically there is a commission or fee if you sell a stock or bond – does this mean stocks and bonds are illiquid?
What is the time limit on liquidity? We use words like immediate or instant liquidity, but unless the money is in our mattress or wall safe we can’t get it this very second. You typically can’t get the money for two days or more when you sell securities; is this liquid? A check is called a demand deposit, but the bank can stop access to those funds for a week by saying they have concerns over “doubtful collectability”. And if a week delay is viewed as liquid, why wouldn’t the two to four weeks it usually takes to get the check from cashing in an annuity also be liquid?
And then there is the illusion of liquidity. Typically a bank will let you cash in that CD or make that seventh withdrawal from the money market account this month, but they don’t have to. A bond sale settles in two days, unless you were trying to sell many of the mortgage-backed bonds in 2008 for which there were no buyers. And, an extreme case, there was zero investment liquidity in the days following 9 -11. Although that was extreme, governmental authorities in some countries believe that some exchange traded funds (ETFs) could become illiquid during a market panic. The financial markets, banks, and even governments all operate on the illusion of liquidity believing there will always be buyers, enough people paying their debts and a government that will be able to ultimately bailout any crisis, but this is only true if people still believe the illusion.
The illusion of control imagines that you will exercise that liquidity well. In the stock market the mirage is that the investor will sell out of the market just as it begins its fall – or will use the liquidity to keep moving from liquid choice to liquid choice to maximize returns. The reality is that doesn’t happen. Indeed, as Investment Company Institute data shows time after time, the liquidity is used to sell at the bottom of markets and often to leap out of rising markets.
The concept of liquidity is not as clear cut as it first appears. If liquidity is defined as not having a cost then many annuities would be excluded, but so would any ETF, stock or bond where a commission or transaction fee is involved in the sale. If liquidity is defined as having instant access to the funds then every investment is ruled out as well as many bank products. What this all means is you need to ask yourself how you define liquidity and what it means to you.