Liquidity is one of the most common metaphors used in finance, because it’s also the most important. To understand it, think about liquid: liquid flows easily from one place to another, and so if there is a channel for the liquid to go through (a pipe, a stream, a hose), it will go from Point A to Point B naturally and, well, fluidly.
Capital works the same way. Some capital, like U.S. dollars, can naturally and fluidly go from Point A to Point B. All I have to do is offer someone a $50 bill and they will immediately take it. The transaction is frictionless, fast, and easy. Liquidity is the measurement of how frictionless, fast, and easy a transaction is with the form of capital we’re dealing with—in this case, U.S. dollars, or, more abstractly, a sovereign nation-denominated currency.
On the opposite extreme of the liquidity spectrum would be ultra-luxury real estate, like mansions worth tens or hundreds of millions of dollars. The total number of buyers of these properties is small, so exchanging ownership of the property from Person A to Person B is difficult for that reason, but there are also a lot of legal procedures that need to be done with real estate (title searches, property inspections, etc.). Real estate tends to be one of the most illiquid types of property, and because of the small pool of buyers, ultra-luxury real estate is the most illiquid of all.
And then there’s real estate that is arguably 100% illiquid and thus worthless. Take, for instance, the White House. How much could the U.S. sell this house for if they wanted to? That number is astronomical, but the political, legal, economic, jurisdictional, and geopolitical ramifications of actually trying to sell the White House would essentially make such a transaction impossible. From this perspective, the White House is unsellable, which you could say makes it priceless, but from an accounting perspective, also means it has a dollar value of $0.
This is one way to understand liquidity: it has its own value, and when taken to extremes it can make a very valuable piece of capital worthless if it has zero liquidity. This is a roundabout way of describing liquidity premium, or the extra price that a person will pay for an asset that is more liquid.
In finance, calculating the liquidity premium of an asset is extremely important. For instance, imagine you want to invest $1 million in property in New York City or in rural Latin America. The higher demand for $1 million in NYC property means reselling that property will be much easier—a million dollar-property in rural Latin America may be much harder to find a buyer, so your investment is less liquid.
There is another important aspect of liquidity, especially when it comes to funds. More liquid assets can be sold in a crash or during a market panic—or, as is often an issue for fund management, if investors want their money back. Understanding the liquidity of your overall portfolio will tell you to what extent you are vulnerable to forced selling—i.e., if there is a market crash, how much will you need to sell in order to keep your fund afloat? Many tactical hedge funds exist solely to provide liquidity to funds and companies in distress—that is, companies who are forced to sell but don’t want to sell. This is a situation no one ever wants to be in, because it can mean selling far under the intrinsic value of your asset.
Understanding what liquidity is and maintaining a certain amount of liquid assets is the cornerstone of fund management, bank accounting, and financial regulation. It is crucial to be aware of how liquid an asset is when purchasing it, because you never know when you will want—or need—to sell it.