Liquidity risk is the potential of a financial instrument to be difficult to trade and settle without having a major influence on its market price. This type of risk has long been an important factor for financial institutions to consider, but for some reason, it hasn’t quite caught on among individual investors who trade in the markets. In this article we’ll look at why that is, and suggest some ways that investors can incorporate liquidity into their investment strategies.
What is Liquidity Risk?
Liquidity risk is the possibility that a security cannot be traded quickly enough or in sufficient volume at its market price. When liquidity is low, the price of a security may be affected, due to buyers and sellers finding it more difficult to get in and out of positions. Liquidity risk can apply to a variety of different securities, including stocks, bonds, commodities, and currencies.
Why Hasn’t Liquidity Risk Caught On?
There are a few reasons why investors and traders have been slow to embrace liquidity risk as a factor in their investment strategies.
Lacking Standards and Guidelines
A primary issue is that there aren’t many standards or guidelines in place to define what truly constitutes a “liquid” security. While some exchanges have rules regarding minimum times and volumes of trades, there is no universally accepted standard or measurement of liquidity.
Lack of HistoricalData
Due to the fact that liquidity risk is largely a subjective concept, there is a lack of historical data that can be used to compare the liquidity of different securities or markets. This makes it difficult for investors to make educated decisions about the liquidity of a security before investing in it.
Lack of Awareness
Another factor is a lack of public awareness about the concept of liquidity risk. Many investors are still not aware of the potential risks associated with low liquidity, or the ways in which it can affect the price of a security.
How to Incorporate Liquidity Risk into Investment Strategies
Although liquidity risk is a subjective concept that can be difficult to quantify, there are several steps investors can take to incorporate it into their investment strategies.
Research
The first step is to conduct research on the liquidity of a potential investment. Check the average daily trading volume and look for any other signs that suggest the security may not be highly liquid.
Monitor the Market
Once you’ve identified a potential investment, it’s important to regularly monitor the markets and the security itself. Look for any signs of reduced liquidity, such as increasing bid-ask spreads or decreased trading volumes. If liquidity is low, consider avoiding the security or reducing your exposure.
Avoid Illiquid Securities
Whenever possible, avoid investing in securities with low liquidity. This will minimize the risk of your investments being affected by reduced liquidity.
Set Limits
If you are investing in a less liquid security, you should set reasonable limits on your exposure. This will help you to limit your potential losses if the security experiences a liquidity crisis.
Liquidity risk is an important factor that all investors should take into consideration when making investment decisions. Although liquidity risk has been slow to catch on among individual investors, there are several steps that can be taken to incorporate it into their investment strategies. By researching and monitoring the liquidity of a potential investment, setting reasonable limits on their exposure, and avoiding illiquid securities whenever possible, investors can help to safeguard their investments and protect their portfolios from the risks associated with low liquidity.
