Understanding Market Liquidity and Your Investments

When it comes to securities investing, market liquidity refers to how easily you can buy or sell an investment at a fair market price when you want to. When a security is illiquid—meaning it has low market liquidity—finding a buyer when you want to sell might be difficult. You might have to accept a lower price if you need to sell quickly. In some cases, you might not be able to sell at all if no one is willing to buy at a price you’re willing to accept. If you want to buy an illiquid security, you might have to pay a higher price or wait longer to find a seller.

Generally, securities with higher trading volume are more liquid. Executing a large order quickly in a low-volume security can be difficult. Additionally, illiquid investments often have a wide bid-ask spread, which is the difference between the price a buyer is willing to pay (the bid) and the price a seller is willing to accept (the ask). A narrow spread can indicate good liquidity but doesn’t provide a complete picture on its own.

Other factors, including how many participants are trading at various prices, can also impact a security’s liquidity.

Why Market Liquidity Matters

Market liquidity can affect your investment returns. Large bid-ask spreads can reduce returns by increasing the buy price or lowering the sell price. Trading illiquid securities can involve additional—and sometimes substantial—costs.

At times, it might be difficult to sell an illiquid security at any price. If you need immediate access to funds that are tied up in illiquid investments, such as for a mortgage payment or emergency need, this could lead to financial problems for you in other areas.

Illiquid investments can also be hard to value. Without regular trading, there might not be a clear market price, and value estimates can vary widely.

Some of the factors affecting market liquidity include:

• Security Types – Some securities are more liquid than others. For example, U.S. Treasury securities tend to have high liquidity, while bond liquidity varies from one bond to another.
• Market Capitalization – The total value of a company’s outstanding shares of stock is referred to as market capitalization, or market cap. Large-cap stocks are usually more liquid than small- or micro-cap stocks.
• Market Stress – During times of crisis or market volatility, investors often seek lower-risk assets. This might drive interest in the most liquid securities, while illiquid investments might become even less liquid.
• Market Sentiment – Positive sentiment toward a security or the market generally can increase trading interest and liquidity. Negative sentiment can have the opposite effect.
• Trading Hours – Extended-hours trading might offer less liquidity because fewer transactions occur outside regular trading hours, resulting in fewer buyers or sellers available to take the opposite side of your trade.

Planning for Market Liquidity Risk

Here are some ways to limit your exposure to or manage the impact of market liquidity risk:

• Investing in Liquid Assets – Choosing investments with higher liquidity lessens market liquidity risk. For example, well-known stocks with higher daily trading volumes are generally more liquid than low-priced, low-volume or obscure securities.
• Diversifying Across Liquidity Levels – Having a diversified portfolio can help limit market liquidity risk since different assets might face liquidity concerns at different times. Avoid putting all your money in hard-to-sell investments, which could limit your ability to trade when needed.
• Matching Liquidity to Your Timeline – If you choose to invest in illiquid assets, do so with money you won't need to access quickly. Selling at the wrong time might be difficult or could result in a lower payout. Keep some portion of your investments in highly liquid assets for use in case of emergencies.
• Using Limit Orders – Limit orders—which are orders you give to your brokerage firm to buy or sell only at a specific price or better—don’t limit your exposure to market liquidity risk but are a tool you can use to manage the impact of illiquidity. They prevent you from accepting an unwanted price when trading in illiquid markets. However, a limit order might sit unfilled if there aren’t enough buyers or sellers at your specified price or better. In other words, limit orders give you control over price but don’t guarantee execution.

Consider talking with an investment professional about how product characteristics impact liquidity and how to achieve your financial goals. Use FINRA’s free BrokerCheck tool to research the background and experience of investment professionals and firms.

Learn more about risks associated with investing.