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Saturday, October 22, 2011

Two major aspects of Liquidity

There are two aspects of liquidity:

A. How readily an asset can be turned into cash.

The ease with which buyers and sellers can be brought together and can agree on a price is called liquidity.

An important consideration in assessing risk is how liquid various financial assets are. Therefore, assets that are less liquid tend to have a wider spread between the "bid" (the price offered by a would-be buyer) and the "ask" (the seller's asking price).

Cash Is King: You need cash and liquidity for freedom and security. The cash in reserve provides money for not only emergencies but opportunities as well.

A cash reserve provides the foundation for your entire financial position. You should get your cash reserve in order before taking on any risky investments with money you can not afford to lose.

Boring but Prudent: Five to six months "salary or seven to eight months" expenses are guidelines generally considered reasonable for emergency reserve funds.

B. An important factor when choosing which stocks to buy is liquidity.

This type of liquidity is best measured with volume. Higher the average daily volume is, higher the liquidity is. High liquidity ensures that at the moment when we want to buy or sell shares, there will be enough sellers/buyers on the other side of the fence.

Before investing in any stock, one major element that you have to look at is the company's daily volume. The daily volume of a company (liquidity) is the amount of shares that are traded on any day.

Most of the stocks that have minimal volume, 1000 shares per day or less, have a problem, and there are numerous reasons you should try to avoid such low volume stocks.

One reason is that stocks with low volume often have very large price swings.

These fluctuations are due to the laws of supply and demand. If there is only a few available sellers of the stock you want to buy, you are forced to pay what they want for the stock.

On the other hand, when you decide to sell the stock, you may be forced to keep the shares because there are no buyers of the stock, or to sell them in a really low price.

Since the low volume stock is "handled" by only a few persons, the stock is usually get hammered down harder than most stocks, and it is also more easily "treated" going up.

Stockholders of these type of companies are often very easily frustrated, and unless they are prepared to hold them for long periods, they very easily panic and sell their stock to the very first offer.

Nevertheless, you shouldn't judge companies solely on their average volume. Volumes tend to increase over time for companies delivering continuous growth in revenues & profits and rewarding share holders by paying regular dividend.

If the company's fundamentals are strong, you should not rule out the possibility of purchasing any stock of the company, but you must do a thorough research before making any final decisions.