What are illiquid assets?
Illiquid assets are those that cannot be sold quickly or easily without the risk of incurring a significant loss. If you are looking to sell, things are generally easier if the asset you are selling is liquid.
Most portfolios will include a mix of liquid and illiquid assets. There are advantages and disadvantages to owning each of them.
What are illiquid assets?
Illiquid assets are things like real estate, retirement accounts or collectibles that can’t quickly be converted into cash without a significant loss of value. This could be due to price fluctuations or difficulty finding a buyer. There might be regulations or penalties on the sale of the asset. Selling these assets often takes considerable time and effort. In addition, the process may require a large amount of paperwork and legal fees.
The potential difficulty in selling illiquid assets is one of the big risk factors. The value of those assets are dependent on market conditions. This can force you to lower the price to make a sale, potentially losing money on the investment. Though, it can also lead to higher returns.
Illiquid asset examples
- Real estate
- Includes housing, commercial buildings and land. One of the most common types of illiquid assets, real estate can take months or years to sell in order to make a profit — and even then, there is no guarantee.
- Retirement accounts
- Retirement accounts like 401(k) are illiquid because, depending on your age, you may be unable to withdraw money from them without a penalty.
- Collectibles
- This might include items like art, antiques and rare coins. Although these items are often valuable and can appreciate in price, finding a buyer can be challenging.
- Private equity
- Investing in a private company is considered illiquid because its shares are not publicly traded and it could take years to see a return on that investment. Getting in early on a high-growth company can lead to big profits but there is also the risk that you won’t make a profit at all.
- Long-term bonds
- Certain bonds can be illiquid, such as those with long maturity dates, which means it could take years to make money on that investment. And there is also the risk that demand on the secondary market could be low if you’re trying to sell them that way.
The common thread with illiquid assets is that you often must hold them for a long time before you can sell and make a profit. Considering this and your liquidity needs before investing in any of the above is important.
What is the difference between liquid and illiquid assets?
The simplest way to contrast these two asset types is their ease of selling. Liquid assets, like cash or stocks, are readily accessible. There is a robust and active market for liquid assets, letting you sell or have access to those funds without waiting. For example, if you own stock in a publicly traded company, you can quickly sell it, converting it into cash the same day.
Illiquid assets are more difficult to convert into cash. The market for these assets is often less active, with fewer buyers looking for them daily. This means selling them at their full market value or at a profit may be more difficult. Often to make a profit you must hold the asset for a period of time. Or, if you need to sell quickly, you may have to reduce the price and risk a loss.
Why invest in illiquid assets?
There are several advantages to investing in illiquid assets.
You might buy real estate as your primary residence or to generate cash flow if you are renting it out. Although real estate can be challenging to sell, the potential to make a profit can make it a desirable investment.
There is also the potential for higher returns. For example, investing in private equity can have the potential for bigger profits than shares in a publicly traded company. However, these investments can also be riskier. Investors may be rewarded with higher returns, but it is also more difficult to sell investments in a company that is not publicly traded.
Some investors may use illiquid assets as an inflation hedge. Real estate can serve this purpose, increasing in value as inflation rises. Although they might be more difficult to sell than liquid assets, illiquid assets can help investors preserve wealth.
Benefits of illiquid assets
Illiquid assets can potentially have higher returns than liquid assets. We see this in examples like real estate, collectibles and private equity. They also allow investors to diversify their portfolios.
These assets also help investors with long-term investment strategies, such as wealth-building or retirement. Retirement might be years away, so investors may not need to sell these assets in the near future, setting them up for a potential profit down the road.
Illiquid assets can also have tax advantages. For example, certain types of retirement accounts may allow you to defer taxes or avoid paying taxes on growth. Real estate may have tax advantages with depreciation and other deductions.
Risks of illiquid assets
The most obvious risk of illiquid assets is liquidity risk. This can make it difficult to find a buyer, forcing you to hold the asset longer, reduce the price or incur a loss.
Market swings can also occur while you hold your asset, causing its value to fall. We saw this during the 2008 financial crisis when housing values collapsed.
Illiquid assets are sold less often than liquid assets, which means there is often less pricing data available. This can make it difficult for the buyer and seller to agree on a price, leading to further delays in the sale.
Bottom line
Liquid assets are generally easy to sell and convert into cash with minimal waiting periods. In contrast, it can be difficult to sell illiquid assets, you may have to hold the assets for a long time and there is always the risk that they may lose value.
However, illiquid assets can have benefits, such as potentially higher returns, diversification and tax advantages.
Some common illiquid assets are real estate, retirement accounts, collectibles and private equity. Before investing, you should fully understand the benefits and risks of illiquid assets and consider them as part of a balanced investment portfolio.
