An asset is considered illiquid if it is difficult to immediately convert it into cash without incurring substantial costs. This may take some time. Although illiquid assets offer several benefits, which we will go over later, they are not the best choice for handling unexpected costs since, in most cases, they cannot be utilized right away.

The ease with which an asset may be acquired and sold on the secondary market is referred to as its level of liquidity. A liquid asset can be sold quickly and easily without incurring significant fees, as well as one with a large pool of possible purchasers. Cash in its physical form and the monies held in a money market, checking account, or savings account all qualify as liquid assets.

Compared to a more liquid asset, an illiquid asset carries a greater liquidity risk, which may be defined as the possibility that an investor would be unable to sell their asset. You can be compelled to hang on to illiquid asset for longer period than you would want, or you might be required to sell it at a significant loss.

If significant expenses are involved in selling an item, the asset may be categorized as illiquid. An example of an illiquid asset would be a certificate of deposit that levies a penalty for making early withdrawals. If you have not yet reached the age at which you are eligible for retirement, your 401(k) is not a liquid asset because, in most cases, you will be required to pay income tax in addition to a 10% penalty on any withdrawals you make from it.

Real estate is one of the most prevalent and widespread kinds of illiquid assets. In the United States, the equity in a home constitutes about 70 percent of a household's total net worth. However, if you want to access the equity in your property, the process might take many months. In most cases, you will be required to sell the house, locate a buyer, negotiate the price, conduct inspections, and execute the closing, among other tasks. Because of the length of time and amount of money necessary to sell it, real estate is considered an illiquid asset.

The Workings of Illiquid Assets

The expenses of transactions

Less liquidity exists in an asset market when more fixed costs are connected with purchasing and selling assets. A stock with a substantial market capitalization that is highly liquid may be bought and sold quickly using an online brokerage account. Purchasing real estate, for example, is a good example of an investment that is likely to be illiquid because of the complexity involved in the transaction.

Lack of demand

It is possible that there will not be a buyer for the item that you want to sell, which would make it challenging for you to sell the asset swiftly.

Private information

It's possible that the buyer won't have access to certain information that the seller has that indicates the asset may perform badly in the future. A potential purchaser could make an offer that is lower than the asset's current market value because there is a possibility that important information is missing.

No centralized market

You may need to negotiate rates and do due research if there isn't a centralized market for your interesting item. Wide bid-ask spreads often result from the absence of a centralized market. This indicates that buyers are prepared to pay a lower price than what sellers are willing to sell for.

Another kind of illiquid asset is something known as a "penny stock." They often trade on over-the-counter markets instead of major stock exchanges such as the NYSE or the NASDAQ. There is a good chance that you will have difficulty selling a penny stock at the time and price of your choosing since tiny stocks often have a low trading volume compared to stocks issued by bigger companies.

Illiquid assets may also be valued personal belongings. Some individuals put their money into treasures such as artwork, baseball cards, or vintage automobiles. They are regarded as illiquid assets due to the absence of a centralized market where quick buyers may be found.

What It Implies for Those Who Invest on Their Own

Although illiquid assets can give dependable returns for lesser risk, which may entice investors to purchase them, this does not make them a good choice for covering unexpected costs. According to the advice of financial gurus, your whole net worth should not be invested in illiquid assets. Keeping some liquid assets at your disposal can enable you to quickly access funds to meet unanticipated costs, such as those incurred for unexpected medical treatment or vehicle maintenance.