Liquidity risk is simply not having enough cash to meet your present obligations. For example, you may own a valuable piece of land but are not able to pay your rent on time.
Some assets are more liquid than others. For instance, you can withdraw some cash from a unit trust to pay school fees but you can’t sell a part of your house. Investments in real estate and businesses potentially pose a liquidity risk. It is not so easy to convert these assets into cash. That’s why they should be viewed as long-term prospects.
Liquid assets include cash, unit trusts, treasury bills and bonds, and shares. These assets can be quickly sold to raise cash to meet pressing needs.
The idea is to have a healthy balance between liquid and illiquid assets. Liquid assets give you the comfort of meeting immediate cash needs while the illiquid assets enable you to preserve and grow value for the long term.
As an investor, you should demand a premium return for incurring a liquidity risk. Otherwise, you should stick to liquid assets if there are no additional returns. For example, there is no economic sense in sinking money into a business which doesn’t offer a significant return over a simple unit trust. The unit trust gives me a fair return with no liquidity risk. On the other hand, I can’t easily recover my capital in a business. So the business must pay me more than a unit trust to be worth my energy and time.
Liquidity risk can also arise from too much borrowing or poor working capital management for businesses. For example, if you over-invest in inventories and receivables you may get cash constrained.
Liquidity risk is something you should watch out for as you play the investment game.