Illiquid stocks are those shares that you cannot sell easily. In other words, such shares do not have a sufficient number of buyers. Even when they can be sold, you may have to incur a huge loss to do so.
In financial markets, the term “liquid” means a sufficient number of buyers for an asset. Hence, an asset’s owner can easily sell it without incurring a considerable loss. An “illiquid” stock is the exact opposite of a liquid stock.
A stock can be illiquid due to a variety of reasons, which we will discuss in detail in this blog. But, whatever the reason, such stocks have low trading activity, which means an extremely low number of buyers are willing to purchase them. Market participants have little interest in such stocks, which can be for many reasons.
Low trading activity makes illiquid stocks inherently riskier than liquid stocks. As a result, illiquid stocks often witness considerable price volatility, wide bid-ask spreads, and really low trading volume. Having discussed what illiquid stocks are, let us talk about their features.
Characteristics of Illiquid Assets
No matter what kind of an investor you are, you need to know the characteristics of illiquid assets, which are explained below:
a) Tough to sell: Illiquid assets are difficult to sell because they have a low trading volume. Imagine having a plot of land in which not a single buyer is interested. Naturally, you will find it difficult to sell; hence, it is an illiquid asset. Typically, only a few market participants are interested in such assets.
b) Volatile price: Illiquid assets can be more volatile than liquid assets. As only a few transactions take place in illiquid assets, even a handful of trades can cause their prices to change considerably. Hence, you should be mindful of this aspect before purchasing an illiquid asset.
c) Potential for losses: Typically, only a few buyers are interested in an illiquid asset. Hence, it is tough for the owner of such an asset to sell it at a fair price. However, if he is willing to incur a loss, he may find a buyer. So, the possibility of incurring a loss due to an illiquid asset is very high.
d) Wide bid-ask spreads: If an asset’s bid-ask spread is high, it could be an illiquid asset. This spread can be calculated by finding the difference between the maximum price a person is willing to pay to acquire an asset (bid) and the lowest price the owner’s asset is willing to accept (ask).
Risks Associated with Illiquid Stocks
Before investing in an illiquid stock, you need to know the risks associated with such investments:
a) May take a long time to sell: An illiquid stock, by definition, is hard to sell. At times, you may not find a single buyer for it in the market. Hence, it may take a significant amount of time to sell. So, if you need money urgently, you should stay away from illiquid assets.
b) Difficult to assess their fair value: A stock’s fair value can only be determined if there are a sufficient number of buyers and sellers for it. As more people show interest in it, you can gauge its true value. However, if there are only a handful of buyers for an asset, how will you know its true worth? If you do not know its fair price, you take a big risk by investing in it.
c) Sharp ups and downs in prices: Illiquid stocks are characterized by only a few transactions. As the number of transactions is extremely low, each transaction has a significantly more impact on their prices than in the case of liquid stocks. Therefore, even the price of illiquid stocks can be much more volatile than that of liquid stocks.
Strategies for Investing in Illiquid Stocks
There is no denying that investing in illiquid stocks can be risky. That said, if you still want to invest in such stocks, you should follow these strategies:
a) Use limit orders: You should use limit orders, not market orders, to buy or sell illiquid stocks. This is because limit orders allow you to purchase or sell a stock at a certain price or better. Unless the price is conducive, such an order is not executed, which makes sense, especially in the case of illiquid stocks, as their price can be extremely volatile.
b) Invest small amounts: As illiquid stocks can be a lot riskier than liquid stocks, you should only invest a small amount in them. You must not invest a sizeable portion of your portfolio in illiquid stocks. Instead, most of your investments should be in liquid assets. The risk you take by investing in illiquid stocks can be diversified by your investments in liquid stocks.
c) Diversify your investments in illiquid stocks: If you decide to invest a certain sum in illiquid stocks, it is better to spread that amount across multiple such stocks. This will help you diversify your risk. Conversely, if you invest only in one illiquid stock, you will depend too much on the price movements of that stock, which will increase your risk.
d) Track your investment: You should monitor all your stock market-related investments. However, tracking investments in illiquid stocks is even more important because you never know when you will get an opportunity to sell them. As volumes tend to be low in such stocks, you need to keep an eye on their price.
How to Identify Illiquid Stocks?
Whether you are a new or a seasoned investor, you need to know how to identify illiquid stocks. You would not like to invest in a share thinking that it is a liquid stock while it is actually an illiquid one.
So, the first thing you should check is whether a stock has a low trading volume. If it indeed has a low volume and only a few buyers place their bids for it, it is likely to be an illiquid stock. Mostly, volume tends to be so low for these stocks that it is nearly impossible to immediately sell them.
At times, a seller is able to sell an illiquid stock quickly by taking a huge price cut. So, whether a seller has to wait endlessly to sell a stock or take a huge price cut, both are signs of an illiquid stock.
The second thing you should check is the frequency of a stock’s price quotes. If a share does not get a price quote for several minutes regularly, it is most likely an illiquid stock. Usually, for such stocks, the time between price updates is much longer than in the case of liquid shares.
The third factor you must notice is their bid-ask spreads. A stock’s bid is the highest price a buyer wants to pay for it. However, a share’s ask is the lowest price a seller wants to accept for it.
A huge difference between a share’s bid and ask shows that there is a considerable gap between the maximum amount a buyer wants to pay for it and a seller is willing to accept, which is often the case with illiquid stocks.
Comparing Liquid and Illiquid Assets
It is essential to understand the difference between a liquid and an illiquid asset to become a successful investor. So, please refer to the table below:
Criteria
| Liquid Assets
| Illiquid Assets
|
Meaning
| These assets have a sufficient number of buyers at any point in time. Hence, they can be easily sold without incurring a huge loss.
| These assets do not have enough buyers showing interest in them. So, they are either extremely difficult to sell or they can be sold by taking a huge price cut.
|
Price volatility
| Liquid assets tend to exhibit lower price volatility than illiquid assets because a significant number of transactions take place in such assets on a daily basis.
| Typically, only a few transactions take place in illiquid assets on a daily basis. Hence, their price can be extremely volatile because it depends a lot on a single transaction.
|
Fair Value
| For a seller, it is relatively easier to get a fair value for his liquid assets because several market participants show interest in it.
| Because only a few market participants show interest in buying an illiquid asset (sometimes not a single buyer wants to buy such an asset), it is extremely difficult for a seller to get a fair value for an illiquid asset.
|
Risk
| Liquid assets are easier to sell than illiquid assets. It is relatively easier to get a fair price for liquid assets. Hence, on average, they have lesser risk than illiquid assets.
| Illiquid assets are tougher to sell than liquid assets. Besides, they are often sold after taking a huge price cut. Hence, they are much riskier than liquid assets.
|
Now that you know what illiquid stocks are and liquid stocks are, you can make informed decisions while investing in them.
Conclusion: Navigating Illiquid Investments
If you are about to open a demat account and start investing, then you need to learn how to deal with illiquid investments. That said, even seasoned investors need to thoroughly know what to do with such assets.
Before investing in such assets, you need to analyse their risk-return profile. Besides, you must ask yourself why you need to invest in such assets. If you want to invest in illiquid stocks, you must use limit orders to reduce the probability of losses.
At no point in time should you invest a considerable portion of your portfolio in illiquid assets because they can be extremely difficult to sell. Last but not least, if at all you want to make such an investment, you must track it actively.