What is an example of liquidity risk?

Liquidity risk refers to the potential difficulty of selling an investment quickly enough at a fair market price without incurring significant loss. When an asset has low market demand, it implies that finding a buyer might take time or may require selling at a lower price than expected, thus exposing the owner to liquidity risk.

In the case of owning property with low market demand, such as a specialized piece of real estate in a declining neighborhood or a niche market property, the likelihood of quickly turning that asset into cash becomes uncertain. Consequently, if the need arises to access funds rapidly, the owner may face challenges in selling the property or may have to accept a lower offer, demonstrating the concept of liquidity risk.

Investing in stocks typically entails higher liquidity, as they can usually be sold more quickly in the market. Buying a home is also less directly tied to liquidity risk since real estate is not meant for short-term liquidity and often has a more stable market character. Having an emergency fund is actually a strategy to mitigate liquidity risk, as it provides quick access to cash without needing to liquidate investments under duress.