Do not ignore ‘liquidity risk’

Many investors think of “liquidity risk” as something technical they needn’t to be too concerned about.

However, it’s likely to affect everybody at some point.

Liquidity refers to how quickly something can be sold. Shares in Naspers are highly liquid because hundreds of thousands are bought and sold in thousands of deals daily on the JSE.

A Vaalwater game farm is a lot less liquid as there aren’t thousands of people lining up daily to buy one. It’ll therefore take much longer to sell.

If something can’t be disposed of quickly, it’s very difficult to prevent or minimise loss.

If Naspers shares fall and you want to exit, you should have little trouble in selling your holding to someone else, therefore managing your realised loss.

If the bottom falls out of the Vaalwater game farm market, disposing of that property could be almost impossible.

This is why liquidity risk is often spoken about in terms of JSE small cap stocks. A stock like Erin Energy Corporation hasn’t traded in months. Its shares last changed hands in mid-December at R30 per share. However, the only current bid in the market for it is R2.18.

Someone holding Erin would probably think of R30 a share as its value. However, for now they couldn’t sell it for more than R2.18 if they had to. So what is it actually worth?

Any asset is only worth what you can sell it for. If you have to sell something not liquid in a hurry, you may get a lot less for it than expected.

Guaranteed liquidity

A unit trust, locally regulated hedge fund or exchange-traded fund offers guaranteed liquidity. You’ll always be able to buy into or sell out of them.

It follows that if you can’t sell an asset, it’s worth nothing. This is a risk many investing into “alternative”, unregulated investment schemes don’t appreciate.

An infamous example is Mandela Coins bought from dealers who don’t guarantee that they’ll buy them back. If you can’t find a buyer for the coin you paid thousands of rands for, what’s its actual value?

Another example was Electio Alternative Investments, which claimed to be selling baskets of rare earth metals. There was never actually any market into which to sell them. Investors were therefore left holding effectively worthless assets.

This is something to be alert to when considering out-of-the-ordinary “investment opportunities”. If these opportunities involve buying an asset in the belief that its value will increase over time, there must be a buyer for it.