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

1. What is liquidity?
2. Liquidity difference between shares and mutual fund
3. How does liquidity affect investment decisions?

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.

Read Also: How Liquid Funds Offer Instant Liquidity?

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.

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.