Having a variety of financial assets is good for your financial health. But different assets carry different risk. Liquid assets, which include cash and anything that can be quickly sold and turned into cash, carry one set of risks, while other assets carry risks because of the time it would take to convert or sell them. As an investor you can manage liquidity risk to avoid the problems it brings.
Liquidity risk refers to a problem that can occur when too many of your assets are not liquid. These assets are not available if you need cash to pay off a debt, make a major purchase or pursue a new investment opportunity quickly. Liquidity risk also refers to the chance that you won't be able to sell an asset quickly when its value reaches a certain point. The time delay in selling certain assets can be a problem if the value falls before you can sell, reducing the amount you earn from the transaction.
A diversified investment portfolio can help you avoid liquidity risk without taking any special steps. A diversified portfolio consists of investments that you can sell right away, such as bonds, as well as long-term investments that are not liquid, such as CDs. Keep enough of your assets liquid to cover your short-term obligations. This will allow you to sell your long-term investments when they have risen in value, not when you're desperate for cash and may need to take a loss or limit your profit.
Understand Your Time Horizon
Timing can mean the difference between a good investment and a bad one. As an individual investor, you need a clear understanding of your time horizon to make the most effective investments that will limit your liquidity risk. Your time horizon refers to how long you can wait before needing the money that you have tied up in investments. If you have no immediate need for the money, you can invest in longer-term securities. However, if you're approaching a time when you'll need the money you have invested (such as retirement) you will need to make short-term investments to keep liquidity risk low.
Financial institutions can face the same liquidity risks as individual investors, only in magnified proportions. For a bank or financial firm, liquidity risk means that investments may not be ready to be sold to cover debt. These institutions can avoid liquidity risk by minimizing their debt, borrowing only as much as they need to cover short-term debt and making plans to sell off investments in the future in order to cover longer-term debts instead of borrowing even more.