Have You Thought About Liquidity Risk Lately?

Why it's so important - especially if you're looking thinking of selling soon

Ian Tam, CFA 5 October, 2020 | 12:58AM

Empty Grocery Store

On Thursday of last week, the Canadian Securities Administrators published guidance directed toward investment fund managers on how to maintain an effective liquidity risk management framework.

The guide, though not directed toward the retail market, serves as a reminder that liquidity risk is something worth thinking about even for the everyday investor.

Here’s why it matters.  

The consequence of liquidity risk is what happens when you try to ‘cash out’ on and investment and you are forced to accept a lower price than what you had expected, or you are not able to sell your investment at all. This is a very real risk to take on especially for those that are nearing retirement.

Liquidity risk occurs in markets where there are very few buyers and sellers. Because there are fewer people, it becomes more difficult to determine the correct price to sell or buy an asset for and to actually transact at that price. In the housing market, this is what happens when you try to sell your house to meet some financial obligations and find that you can’t sell your house for the price that you were expecting to get. In the stock market, this might happen when an investor tries to sell a large number of shares of a penny stock all at once only to find that there isn’t any demand for those shares (and hence he is forced to hold onto the shares or sell them at a lower price). The less liquid an asset is, the more risk you are taking on.

Relationship between size and volume

The above chart shows the 695 companies in the Morningstar® CPMS™ database as a scatterplot comparing each company’s size to the average amount of shares traded each day over the last three months. If you were to try to trade 100 shares of RBC or Shopify, you’d likely have no issue selling right away. But if you were to try to sell 100 shares of a much smaller stock, it is likely that you may either have to accept a lower price or have to make the trade over a number of days. Broadly speaking, paper assets (like stocks, bonds and cash) are much more liquid than hard assets (like real estate). Certain vehicles that have set redemption periods like closed-end funds, hedge funds, venture capital or private equity funds also have some element of liquidity risk but can be managed if investors ensure that they are fully aware of the said redemption schedule.

Unfortunately, the downfalls of liquidity risk are only observable when you transact on an asset. If you are younger and have a long investment time horizon, liquidity risk is likely not going to be an issue since you don’t need to sell your assets in the near term. However, if you are nearing the time when you need to withdraw your investment (i.e. retirement), liquidity should be something on your mind. In other words, are you going to have any trouble selling your investments at the price that you are expecting to receive? If the answer is “I don’t know” or “yes” it might be worthwhile speaking with your advisor for a quick look through your investment portfolio.

This article does not constitute financial advice. It is always recommended to speak with an advisor or financial professional before investing.

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About Author

Ian Tam, CFA  is Director of Investment Research at Morningstar Canada. 

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