Why liquidity is important

B. Venkatesh

THERE is still investor fancy for technology stocks, ranging from Mascon Global to Infosys Technologies.

But analysts have been discouraging retail investors from buying certain stocks, not because they do not hold growth potential but because these stocks are not liquid.

Why is liquidity an important factor to be considered for investments? Because liquidity helps reverse your investment decisions.

Suppose you buy 10 shares of Infosys at the current price, hoping the stock will climb in the next fortnight. What if the stock falls instead? You can easily sell the shares and reverse your investment decision if your bet turns wrong.

But instead of Infosys Technologies, what if you had bought Mascon Global? You would have found it extremely difficult to sell the shares; for the stock's liquidity is low. Why is this so?

Most often, liquidity is directly related to the degree of control. Take Infosys or Hindustan Lever. These stocks are highly liquid because the managements of these companies do not control substantial proportion of the respective company's stocks.

In other words, the shareholder base comprising of small investors is large. This reduces the management's control on trading of shares and increases liquidity. You are, therefore, able to easily buy and sell these stocks.

This is quite contrary to what you can do if you are invested in, say, Wipro or Mascon Global; for the managements of these companies hold a substantial proportion of the company's stocks.

The link between liquidity and control holds good for all kinds of investment. Consider a bank that has a choice between extending a loan of Rs 10 lakh or investing in bonds.

The bank enjoys more control if it extends a loan. But it has to sacrifice liquidity because the bank will have to hold on to the investment till maturity. In other words, it cannot reverse its investment decision easily. In financial parlance, the bank is said to run a liquidity risk. In short, the next time you make an investment decision, it would be best to consider the liquidity factor as well.