What is liquidity in shares and mutual funds
Investing in the financial markets can be rewarding, but it's essential to understand the various concepts that can influence investment decisions. One such crucial factor is liquidity. In this article, we will understand the meaning of liquidity, how it can impact your investment decisions, and the difference between shares and mutual funds with regard to liquidity.
- Table of contents
- What is liquidity?
- Liquidity difference between shares and mutual fund
- How does liquidity affect investment decisions?
- Exploring the flexibility of liquid funds: Suitable for short-term needs
- Understanding the investment strategy of liquid funds for short-term goals
- Benefits of liquid funds in short-term investment horizons
- Benefits of liquid funds in business expansion
- Managing cash flow
What is liquidity?
Liquidity means the duration and expense involved in converting an investment into cash. The higher the liquidity of an asset, the more seamless is the process of turning it into cash. On the other hand, less liquid assets require more time and may incur higher costs for conversion to cash.
Cash holds the distinction of being the most liquid asset due to its swift conversion speed and ease of transition to other assets. On the contrary, tangible goods – such as fine art, real estate, and collectibles – are assets that are relatively illiquid.
For instance, consider an individual who wants a branded outfit worth Rs. 8,000. Cash, being the most liquid asset, is the most convenient means to buy this outfit. In contrast, if the person lacks cash but has a renowned painting valued at Rs. 8,000, finding someone willing to directly exchange the painting for the outfit is unlikely. Instead, the individual would need to sell the painting and obtain cash that can then be used to purchase the outfit.
Liquidity difference between shares and mutual fund
Liquidity in shares
The liquidity difference between shares and mutual funds refers to how quickly and easily one can buy or sell these investments in the market. Below we have elaborated on the liquidity difference between these two investment options.
Shares, or stocks, represent your ownership in a company. Now, how do you assess the liquidity of a stock? It's all about trading volume – the number of shares being bought and sold.
Highly liquid shares are like popular items in a busy market. These are stocks of well-known companies, often called blue-chip stocks. Think of giants like Apple, Microsoft, or Google. Their shares are traded frequently on stock exchanges, making them easy to buy or sell at the current market prices.
On the other hand, less liquid shares don't get traded as often, which can make it difficult to find a buyer or seller when you want to make a transaction.
Liquidity in mutual funds
Mutual funds are an investment option, wherein multiple investors pool their money, and a fund manager uses that money to invest in a mix of stocks, bonds, or other assets. The liquidity of a mutual fund depends on the liquidity of the assets it holds.
If a mutual fund invests in things that are easy to buy or sell, like popular stocks or government bonds, it's considered more liquid. This means you can buy or sell units of the mutual fund without much trouble. On the other hand, if the fund has investments that are less commonly traded, it might take more time to cash out your investment.
Also, unlike shares, mutual fund units have an exit load. It is the fee AMCs (Asset management companies) charge the investor at the time of exiting or retrieving the units of the fund.
Read Also: Mutual fund vs direct equity: Understanding the difference
How does liquidity affect investment decisions?
Liquidity significantly influences investment decisions by determining how easily an asset can be bought or sold without impacting its price. Here’s how it impacts investment decisions.
Risk management: Highly liquid assets usually involve lower risks as you can quickly buy or sell them without causing significant price changes. Low liquidity may lead to higher costs and more significant price swings, making your investment journey a bit more unpredictable.
Emergency situations: Liquidity is vital in emergencies when you might need quick access to cash. You can quickly convert assets into cash without losing much value. Less liquid investments may take longer to sell, which could be a challenge during emergencies when you need to access cash quickly.
Investment horizon: Short-term investors may prefer highly liquid assets for quick transactions. For long-term investors, it may not be a significant concern. They can afford to wait for the market to settle.
Market conditions: Liquidity can be influenced by market conditions. During uncertain times, liquidity may decrease, making it harder to sell assets.
Exploring the flexibility of liquid funds: Suitable for short-term needs
One of the key reasons why individuals invest in liquid funds and consider them suitable for short-term needs is their flexibility. Liquid funds allow investors to enter or exit the fund at any time without incurring any significant exit load. Any investor can exit the liquid fund without exit load after staying invested for 7 days. This flexibility makes them ideal for meeting short-term financial goals that may require access to funds on short notice. Moreover, liquid funds tend to offer a relatively better return potential compared to traditional savings accounts or fixed deposits. While the returns may vary based on market conditions and the fund's performance, liquid funds aim to provide optimal returns within a short-term investment horizon. However, unlike savings account, the returns from liquid funds are not fixed in nature.
Understanding the investment strategy of liquid funds for short-term goals
To comprehend the investment strategy of liquid funds for short-term goals, it is essential to analyse the underlying instruments in which these funds invest. Liquid funds primarily invest in money market instruments and debt securities with a short maturity period of upto 91 days. These investments ensure liquidity and relative stability while aiming to generate reasonable returns in line with the prevailing market conditions.
Additionally, the investment strategy of liquid funds focuses on maintaining a low average maturity period for the portfolio. By doing so, these funds aim to mitigate interest rate risks and ensure relative stability within the short-term investment window. This strategy allows investors to have peace of mind while knowing that their funds are parked in relatively low-risk avenues.
Benefits of liquid funds in short-term investment horizons
- Liquidity: As the name suggests, liquid funds are highly liquid. This means that investors can redeem their investment at any time, typically receiving the proceeds within one business days. Liquid funds provide an option of insta-redemption for resident retail investors up to 50,000 rupees or 90% of amount invested whichever is lower. This feature makes liquid funds suitable for short-term goals that may require immediate access to funds. If investors stay invested for 7 days, they can exit the liquid fund without paying any exit load.
- Mitigate impact to Capital: Liquid funds focus on investing in low-risk instruments, aiming to mitigate the impact on the capital invested. While they usually do not provide extravagant returns, the emphasis on less volatility and limited impact on capital invested is crucial for short-term goals where relative stability is paramount.
- Low volatility: Since liquid funds primarily invest in short-term debt instruments, they are relatively less volatile compared to equity funds. This characteristic ensures that the value of your investment does not fluctuate significantly, providing a sense of relative stability within the short-term investment horizon.
- Diversification: Liquid funds offer diversification benefits by investing in a variety of money market instruments. Diversification helps in spreading the risk associated with investing in a single instrument, providing a more balanced investment approach.
Considering the flexibility and benefits offered by liquid funds, they can be an attractive option for individuals looking to meet their short-term financial goals. However, it is essential to remember that every investment decision should be made after careful consideration of one's financial situation, risk tolerance, and investment objectives. Seeking the guidance of a financial advisor or distributor can provide valuable insights and help in making well-informed investment decisions.
Benefits of liquid funds in business expansion
Relatively less risky: Liquid funds are known for their low/low-to-moderate risk profile. They invest in high-quality, short-term market instruments, which are less susceptible to fluctuations due to the lower maturity period. This low risk feature is particularly beneficial for businesses in expansion mode, as it ensures relative stability in their investment.
High liquidity: One of the key features of liquid funds is their high liquidity. Businesses can withdraw their investments at short notice, often within 24 hours. This immediate access to funds is crucial for meeting unexpected expenses or seizing sudden market opportunities during expansion phases.
Flexibility: Liquid funds offer great flexibility. Businesses can choose the amount they wish to invest and can withdraw their funds subject to exit load. This flexibility allows for better financial management, especially given the unpredictable nature of business expansions.
Relative stability of principal amount: The prevention of erosion of the invested capital is a prime concern for businesses. Liquid funds, with their investment in low/low-to-moderate risk instruments, provide relative stability for the principal amount, making them a suitable option for businesses looking to expand.
Relatively stable returns: While liquid funds are not designed for high returns, they do offer modest gains. This is particularly appealing for businesses that prefer a steady growth in their investments, complementing their expansion efforts.
Managing cash flow
Effective cash flow management is important for any expanding business. Liquid fund investment can play a crucial role here. By parking surplus cash in liquid funds, businesses can earn potential returns while keeping the funds accessible. This strategy ensures that the business is never cash-strapped and can meet its short-term financial obligations without difficulty.
Additionally, the use of liquid funds as a part of cash flow management allows businesses to maintain a healthy balance between liquidity and investment. This balance is crucial during periods of growth, where cash flow needs can be unpredictable and often immediate. By having a portion of their assets in liquid funds, businesses can be assured of having a buffer that earns returns yet is available when the need arises. This approach helps in smoothing out cash flow cycles, particularly important during phases of rapid expansion or when dealing with seasonal fluctuations in business.
Conclusion
To sum up, liquidity affects investment decisions by influencing risk management, response to emergencies, investment horizon, and consideration of prevailing market conditions. Thus, understanding liquidity is an essential part of the investment journey. While liquidity is important, it's equally crucial to plan your investments. An SIP mutual fund calculator can help you determine the optimal investment amount and frequency.
FAQs:
What is liquidity in mutual funds?
Liquidity in a mutual fund refers to how easily you can buy or sell units of the fund without affecting its market value. It depends on the liquidity of the underlying assets the fund holds. The easier it is to trade, the more liquid the mutual fund.
What is liquidity in shares?
Liquidity in shares, or stocks, is about how easily you can buy or sell them in the market. Highly liquid shares are actively traded, while less liquid ones may not change hands as frequently.
How does liquidity affect investment decisions?
Liquidity affects investment decisions because it influences the risk associated with your investments and how easily you can access funds. Among other things, your financial goals, investment horizon, and prevailing market conditions can influence how liquid you need your investment to be.
Can I set up systematic investment plans (SIPs) in liquid funds?
While liquid funds are primarily used for short-term investing, it is possible to set up a systematic investment plan (SIP) in these funds. SIPs allow investors to invest a fixed amount at regular intervals, thereby providing them a systematic and disciplined approach to investing.
Can I use liquid funds for emergency fund purposes?
Yes, you can use liquid funds for emergency purposes. Liquid funds provide easy liquidity and relatively stable return potential.
What factors should I consider when selecting a liquid fund?
When selecting a liquid fund, you must take into consideration factors such as the expense ratio, credit quality, expertise of fund manger and the fund’s investment objective. Do not forget to read the scheme’s offer documents for detailed information. You can also seek the help of a financial advisor to make an informed decision.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.