Liquidity Risk
Not every investment can be sold quickly. Liquidity risk is about whether you can convert your investment to cash without taking a significant loss.
What Is Liquidity Risk?
- Liquidity risk is the risk of being unable to sell an investment quickly without a significant price concession
- An illiquid investment may take weeks or months to sell, or you may need to accept a steep discount to find a buyer
- Liquidity risk is a major consideration for alternative investments
Liquidity Spectrum
| Highly Liquid | Illiquid |
|---|---|
| U.S. Treasury securities | Direct Participation Programs (DPPs) |
| Large-cap stocks | Non-traded REITs |
| ETFs | Hedge funds |
| Open-end mutual funds | Thinly traded stocks |
| Money market instruments | Restricted securities (Rule 144) |
Key Points
- Open-end mutual funds are highly liquid because investors redeem shares directly from the fund at net asset value (NAV), calculated daily
- Closed-end funds trade on exchanges like stocks; liquidity depends on trading volume
- Alternative investments (DPPs, hedge funds, non-traded REITs) often have lock-up periods or limited redemption windows, making them among the least liquid investments
- Restricted securities under Rule 144 cannot be freely sold until holding period requirements are met
Think of it this way: Imagine trying to sell your share of a private real estate partnership. There is no stock exchange to list it on, no ticker symbol, and no daily price quote. You have to find a willing buyer on your own, and that buyer knows you are in a hurry. That gap between wanting to sell and actually getting cash is liquidity risk.
Exam Tip: Gotchas
- The most illiquid choice is almost always an alternative investment (DPP, non-traded REIT, hedge fund) rather than a publicly traded security.
- Open-end mutual funds are among the MOST liquid investments. You can redeem at NAV any business day. The exam may pair them against alternatives to test whether you know the difference.
Liquidity risk is specific to certain investment types. Next, we'll examine a risk that affects the entire market at once: systematic (market) risk.