When discussing liquidity, we are delving into the ease and speed at which an investment asset can be converted into cash, ideally at its fair market value. Illiquid investments refer to assets that cannot be swiftly or easily traded for cash and are often less connected to major markets like the stock market, offering diversification benefits in a portfolio. While illiquid assets can be owned and invested in by anyone, they frequently come with a higher price tag that can act as a deterrent for many investors. In this article, we’ll explore the intricacies of illiquid assets and how they might align with your investment strategy.
A conversation about illiquid investments in Canada must begin with real estate. Canada boasts one of the world’s most dynamic real estate markets, making it a preferred illiquid investment choice for both Canadians and international investors.
Why choose real estate? In cities like Vancouver and Toronto, real estate prices have demonstrated consistent growth over several decades, offering substantial returns to property owners. Unlike stock markets, real estate markets do not experience frequent crashes, adding stability to this asset class. However, the significant barrier to entry lies in the substantial down payment required, which has limited access for younger investors.
Regarding liquidity, real estate is highly illiquid. Selling a property quickly can be challenging, and there are no guarantees of receiving the funds promptly.
Humans have always had a penchant for collecting rare or valuable items, such as artwork or antiques. While these can be excellent investments, they often pose challenges when it comes to converting them into cash, especially if you’re looking for the right buyer.
Collectibles encompass a wide range of alternative investments, many of which carry a hefty price tag due to their rarity and authenticity. This exclusivity makes them less accessible to many potential investors.
In addition to the difficulty of selling, obtaining collectibles can be equally challenging, often requiring purchases through auctions or private art sellers. However, the risk associated with collectibles, like artwork, remains relatively low as long as their authenticity is confirmed. This asset class can be rewarding if you possess the patience to hold them and monitor market demand.
Few assets have maintained their value over centuries like precious metals such as gold, silver, and bronze. These metals have served as investments and trading assets for millennia.
The liquidity of precious metals varies. Investing in physical forms like gold bullion or silver coins falls under illiquid investment assets, as finding buyers at market value can be challenging. Alternatively, you can invest in precious metals through stocks, ETFs, or futures contracts, which offer greater liquidity, although they must be sold during trading hours.
Precious metals are known for their price stability and are often used as a hedge against market volatility, particularly in stocks. This makes them a low-risk illiquid asset with relatively modest return potential.
Stock options, although similar in operation to stock option contracts in the stock market, are typically provided by companies to their employees as a form of compensation.
Stock options grant employees the right to purchase company stock at a specified price during a designated timeframe. Depending on the lockup period for these options, they can remain entirely illiquid until maturity. Even after conversion into company stock, selling is required to convert them into cash.
Guaranteed Investment Certificates (GICs) represent low-risk investment assets offering guaranteed returns for a set amount of capital over a predetermined period, which can extend up to 10 years. As the name suggests, you cannot redeem your investment until the GIC’s maturity date.
These investments can be particularly attractive during periods of high-interest rates and stock market volatility. They entail minimal risk since you are assured of interest payments and a return on your initial investment at the end of the term.
Other fixed-income assets, such as bonds, also serve as safe but illiquid investments. Bonds operate similarly to GICs, requiring investors to allocate a sum of money and receive interest on their principal. Bonds often have longer maturity periods, and redeeming them prematurely may incur penalties.
Most debt instruments are accessible through brokerages or banks. Similar to GICs, they are favored by investors during periods of elevated interest rates and offer low risk, ensuring the return of your principal along with interest upon maturity.
The crux of an asset’s liquidity lies in its ability to be swiftly and effortlessly exchanged for its fair market value in cash. The ability to sell an asset for $20 is meaningless if its true worth is $100.
Illiquid investments typically come with higher price tags and carry inherent liquidity risks. These risks pertain to the likelihood of finding a buyer for illiquid assets during times of market volatility. Furthermore, illiquid assets usually demand a long-term investment horizon, adding complexity to selling or converting them into cash.
Investors opt for illiquid assets to diversify portfolios that might be heavily weighted toward assets like stocks. The stability offered by many of the aforementioned assets is appealing, especially to older or more conservative investors.
However, it’s crucial to recognize that illiquid assets are riskier than liquid ones due to their inherent liquidity risk. During economic downturns, finding a buyer for a collectible car or rare artwork can be a daunting task. This often results in illiquid assets commanding a “liquidity premium,” a slight increase in price to account for the potential difficulty in selling the asset in the future. In such scenarios, selling the asset below its market value is a real possibility, leading to potential losses.
Illiquid investments can enhance portfolio diversification and offer steady gains as their value appreciates over time. They serve as an alternative to the volatility of stocks and other liquid investments.
However, they carry higher risk compared to liquid investments. They can be challenging to both purchase and sell, contingent on market conditions. During economic turmoil, illiquid investments may also be costly and face low demand.
Stocks are among the most liquid investments in Canada. Shares can be sold and converted into cash at their current market value, albeit during market hours from Monday to Friday.
Mutual funds are also highly liquid and can be readily converted into cash. Like stocks, mutual funds usually require selling during market hours.
Short-term bonds that can be redeemed without penalties offer excellent liquidity in Canada. These bonds pay interest and typically have maturity periods ranging from 1 to 3 years.
Cryptocurrencies, such as Bitcoin, are generally considered liquid assets. While they may be less liquid than stocks, most liquid tokens can be exchanged for cash at any time of the day, thanks to the 24/7 trading nature of crypto markets.
No, cryptocurrency is considered a liquid asset. While generally less liquid than stocks, most liquid tokens can be exchanged for cash at any time due to the continuous trading in crypto markets.
The primary distinction lies in how easily and quickly an asset can be converted into cash at its fair market value. Liquid assets can be swiftly converted, while illiquid assets are more challenging to convert into cash.
Yes, a house qualifies as an extremely illiquid asset. Selling a house quickly can be difficult, and the process may not guarantee timely receipt of funds. Houses require finding the right buyer, making them non-negotiable assets for immediate cash conversion.
Yes, physical gold is categorized as an illiquid asset. This includes gold in the form of bullion, bars, or coins. Gold becomes more liquid when represented as stocks, ETFs, or futures contracts trading on an exchange.
Any stock with a low share float is generally less liquid than others. Examples include Over-the-Counter (OTC) or penny stocks, which often have lower trading volumes during sessions.
