What is Illiquid?
Illiquid describes an asset or security that cannot be sold quickly due to a shortage of interested buyers or a lack of an established trading market. Illiquid assets cannot be easily converted into cash without potential for losing a significant percentage of their value.
How Does Illiquid Work?
Examples of illiquid assets include penny stocks, microcap stocks and nanocap stocks; ownership interests in private companies; collectibles like art and antiques; partnership shares in hedge funds and alternative investments; certain types of options, futures and forward contracts; and some types of bonds and debt instruments. Because these assets change hands infrequently, it is difficult for investors to agree on a fair market value. This creates large spreads between the seller’s asking price and the buyer’s offer price.
Liquid markets can become illiquid very quickly. For example, up until 2008, it was not necessarily difficult for a home seller to find a willing buyer, But after the credit crisis began that year, the housing market in much of the U.S. became more and more illiquid.
The most liquid markets are those that continuously have high volumes of buying and selling -- for example, large cap stocks, currencies, treasuries and commodities. Though the balance of buyers and sellers is always shifting, you are almost always guaranteed to find a buyer for these kinds of assets.
Why Does Illiquid Matter?
Illiquid assets are considered more risky than liquid assets. During periods of market volatility, when there are fewer buyers than sellers, illiquid assets may become even more difficult to sell. In fact, a seller may find no willing buyers. In these instances, holders of these assets may be required to discount their asking price to attract potential buyers, and in the worst cases may find that their assets have zero value at certain points in time.
To learn more about illiquid assets, check out: 4 Penny Stock Myths Used to Target the Next Sucker and The Lowdown on Penny Stocks.