Learn the lingo: Liquidity

So you wanna invest in the stock market ... but you still can't speak the language. Well, ladies, if you've been reading the past couple months, I've touched on some essential terms you need to know before you depart on your foray into stock market bliss. Key word being "some," though, meaning there's a whole lot more to learn within this realm.

Which brings us to liquidity. I know, just the sound of it makes you shudder, probably because you're thinking it has some long-winded, snooze-related explanation -- and if you've already gotten this far in life without it, why learn its meaning now? I don't blame you for glazing over these mundane, "liquidity"-related details, but don't hit the snooze button just yet! However dull and boring the terms sound, if you're on the path to becoming financially savvy, you'll need to learn to speak them!

So, back to liquidity, yet another another one of those investment words that sound more complicated than they truly are. Liquidity is basically how quickly you can sell something without taking a loss. Simple, no? To put it in even plainer terms, it's also known as marketability. Say you owned an asset such as a car. How liquid your car (or asset) is depends on how fast you can turn it into cash. So if you buy a car for $8,000 and sell it soon after for the same price or more (if only this happened in reality!), than it would be a liquid asset. If, on the other hand, you had to slash the price to, say, $7,000, and it took longer to sell, it would be considered an illiquid asset.

It's all fine and fabulous when you're talking about personal assets, but how does liquidity come into play in market speak? Easy! To stock market investors, liquidity translates into whether or not a company will experience giant price fluctuations in its stock due to large volumes being traded daily. Stay with me, I promise this gets easier! Let's say you want to invest in a small company who has a low daily volume (or amount of stock bought and sold in the market by investors) of 20,000 shares per day, which is pretty low considering there are many stocks with daily trading volumes of millions!

This smaller, low-volume company (with, for example, five investors buying and selling per day within it) would be considered illiquid and volatile, because any large buy-in by this group of around five could increase its stock price exponentially. This matters to serious investors such as mutual fund managers, who buy millions of stock at a time and don't want their single purchase to artificially inflate a stock's price. This is called market liquidity.

And then there's balance sheet liquidity. (Try dropping that term at your next cocktail party!) A company's balance sheet liquidity is basically any assets a company has (investments, property, bonds, etc.) that can be turned into cash at a moment's notice. Generally a company with high balance sheet liquidity isn't that risky to invest in since they can quicky come up with cash in exchange for their assets if they're ever in a bind. These types of companies usually grow slower than most, though, because assets are kept in storage (so to speak) in case of emergencies, and not outrightly used to generate profits.

Last but not least, liquidity is directly related to a company's overall value (much like the overall value of the car you were going to sell that I mentioned earlier). Take a company that sells scrunchies called Scrunchies, Inc.*

*This is purely for example purposes, it would be highly unprofitable and embarassing in 2008 to A.) sell scrunchies in the first place, and B.) name your company Scrunchies, Inc. Yes, even I used to wear them, but I was an unsuspecting kid in the heyday of the early 90s.

So you're considering investing in Scrunchies, Inc., but you see that it makes most of its profit by, well, selling scrunchies. Being the savvy investor you are, you know that scrunchies may have been popular at one point, but their 15 minutes of fame are up -- they just aren't in demand anymore and people aren't buying them. Would you invest in a company who's products aren't likely to generate that much profit? No, you wouldn't! And that, all you brunettes, redheads, blondes -- or whatever you are -- on a budget, is liquidity. I know, it's a marvelous thing!

Keep it in mind next time you consider investing in a company. Or even if you're just buying a personal item that you hope will hold its value, such as a car or a Louis Vuitton bag. You may think assets such as designer handbags may be good investments, but just how liquid are they? How long would you need to hold on to a bag to sell it used without losing a profit? If you were ever in a pinch and needed to sell it ASAP for cash, would you be able to quickly without losing money? These questions are a good guage of how liquid or illiquid a large purchase will be, and whether or not it fits well within your budget and investment plan.