Liquidity

'Liquidity' means 'How easily can you get at your cash'

If you have money in a current account you can withdraw it at any time without penalty and with little effort. Your current account is said to be highly liquid.

If you have a 30-day building society account there will be restrictions on drawing out your money with less than 30 days notice: either it will be absolutely forbidden or there will be some sort of financial penalty. Either way, a 30-day notice account is said to be 'less liquid' than a current account.

Some investments have such restrictive repayment terms that they are described as 'illiquid'. This means 'jolly difficult to get your money out unexpectedly'.

Reward for illiquidity

If your current account pays the same rate of interest as a 30-day notice account, would you put any money in the latter, all other things being equal? Obviously not. Why place restrictions on your money when you can avoid them at no cost?

So, 30-day notice accounts need to have higher interest rates than current accounts for people to use them. Generally, less liquid investments need to offer higher returns than liquid ones. This is the reward to the investor for giving up liquidity.

The lesson for the investor is...

If you are prepared to give up liquidity you can expect to earn a higher return. More than that, if you give up liquidity you must expect a higher return.

If you want a bit more discussion about liquidity before moving on: Hanging Loose