What is liquidity risk and why does it matter to DIY stock investors

In a world where trading platforms like Clarity, by Investec make it quick and easy for DIY investors to get their share of the market, you might take the ability to buy and sell shares when you want for granted.

One reasons why investors love trading and investing in shares is because they are liquid assets. That means, on most days, it is easy to “liquidate” a position by selling a stock or buying shares or ETFs at the market open or the best bid price.

But have you considered what happens when there are few sellers or buyers? It’s more common than you think. When market liquidity dries up, a DIY investor is no longer able to sell stocks or ETFs (or exit a position) quickly enough to prevent a loss, or at a price that reflects “fair” value.

This is what is commonly known as liquidity risk – the risk of being stuck with an investment that you cannot easily turn into cash without giving a buyer a massive discount (often called the “fire sale” price).

Famous hedge fund manager and founder of Bridgewater Associates described market liquidity with this simple simile: “Liquidity is like oxygen. When it’s present, nobody really notices. But when it’s absent, everybody notices.”

Understanding liquidity

Liquidity is measured by the gap between the price a buyer is willing to pay (bid) and the price a seller is asking for (ask) – a bid price that is significantly lower than the ask price (a wide spread) creates high liquidity risk.

In general, liquidity risk is lowest when trading and investing in the world’s biggest and most popular stocks, like Apple (AAPL-NASQ), Tesla (TSLA-NASQ) and Nvidia (NVDA-NASQ), because the spread is small (or tight) – you can sell instantly at a price very close to the last traded price. There are also many shares of these companies in circulation, and trading volumes are usually high (this means there are many active buyers in the market).

High-risk situations

The various scenarios and circumstances where liquidity risks rise include times when daily trading volume is extremely low, which can happen in after-hours trade, or during a market crash when fear grips investors and the pool of buyers dries up, like during the first weeks of the COVID pandemic.

Shallow markets are rife with liquidity risk because limited market depth means large orders can significantly affect prices. In deep markets, many trades can occur, allowing large orders to have a negligible effect on market prices.

Trading in small-cap stocks also carries higher liquidity risk, because these companies often have fewer shares in circulation, and trading volumes are therefore lower. These thinly traded stocks often have fewer participants, leading to wider bid-ask spreads (higher costs to trade).

Why liquidity risk matters

For DIY stock investors, liquidity risk matters because it can turn a temporary paper loss into a significant, permanent loss if you need to force sell to access cash immediately, like when a personal financial emergency arises or during a market crash.

Another concern is that liquidity risk is often a hidden danger that only reveals itself during market stress, where selling the stock quickly becomes necessary, or when trading or investing in less popular stocks.

Mitigating liquidity risk

DIY investors can protect their portfolios by following a few simple tips:

• Position size appropriately: Don’t invest a large percentage of your portfolio into micro-caps or highly illiquid sectors. Diversify a portfolio across high-volume, liquid large-cap stocks or ETFs that you can sell instantly in any market condition.
• Check average daily volume: Before investing in smaller companies, check their average daily trading volume. If only a few thousand shares trade daily, you may have trouble exiting a large position without moving the stock price yourself.
• Watch the “float”: A stock with a small public float (few shares available for trading) is prone to extreme price swings when a few large buyers or sellers enter the market.
• Use limit orders: Never use a market order for an illiquid stock. A limit order ensures you set the minimum price you are willing to accept, protecting you from flash crashes or thin order books.
• Use stop-loss orders: A stop-loss order ensures your position is closed at your pre-selected price level, offering downside protection when markets fall.
• Build an emergency cash fund: Build a “rainy day” fund in cash or cash equivalents, like money market funds, to avoid the need for forced selling during a market dip.