Side Note: WTF is Liquidity?

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I've used the term "liquidity" and distinguished between liquid and illiquid assets. But I neglected to explain what exactly that means, so let's do that now.

What is Liquidity?

Investopedia defines liquidity as the degree to which an asset can be bought or sold in the market without affecting its price (source).

This means how easy it is to buy or sell your asset without affecting its price.

There are two types of assets:

Liquid Assets

  • liquid asset can be quickly (usually instantly) converted into another asset.
  • There are readily available buyers and sellers for liquid assets at any given time.
  • As a result, you know the real price of a liquid asset in real time. You know exactly what it's worth, no guessing or estimating needed.

Illiquid Assets

  • An illiquid asset is something that has value, but it is more difficult to convert into another asset.
  • It can take a long time to find a buyer or seller with illiquid assets.
  • As a result, you don't know the price of an illiquid asset in real time. It can only be estimated and the true price is discovered when a sale is finally made.

Examples

Here's a simple example, to contrast the two: Bitcoin (a liquid asset) and a house (an illiquid asset).

Bitcoin icon, House

Both of these assets are valuable and the value of both changes over time. Bitcoin is a liquid asset because you can buy or sell Bitcoin 24/7, on dozens of apps and exchanges and it happens instantly. In other words: if you have Bitcoin and you want to sell it, you can do it immediately. You can convert one liquid asset (BTC) into another (cash) without delay.

On the other hand, a house is also very valuable, but it can't be converted into cash instantly. Even in the best case, if you find a buyer immediately, it will take at least a few days for the paperwork to be done and a transfer to clear. But more commonly, a house might be on the market for weeks, months or even years before it sells (depending on current market conditions). In poor market conditions, you may discover that your house is worth a lot less than you thought - i.e. you have to sell it at a discount.

Liquidity is Variable

The liquidity of an asset is not static. The ability to convert one asset into another can change over time because the amount of buying and selling happening changes over time.

Example: If you're trying to sell your house but can't find a buyer, your house is considered very illiquid. But if you're trying to sell your house and multiple people want to buy it, means your house is very liquid right now.

In this case, liquidity is how easy it is to sell your house at a price that you think your house is worth (or more).

Why I Don't Track Illiquid Assets

I don't track illiquid assets in my Net Worth Tracking sheet. For example, I don't have a line there that says "Thrive Themes" and lists an estimate of how much that business would be worth, if I sold it.

Why not?

Because I'd be fooling myself. A business is a highly illiquid asset. Most businesses never sell. Of course, I can look at customers, revenue, growth etc. and estimate what the business is worth, but that doesn't mean there will ever be a buyer for it.

If I tracked the value of a business in my personal Net Worth Tracking sheet, I'd just be making myself feel good about a big number that might never materialize.

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