Liquidity is the first consideration when deciding to invest in a market. Why? Because liquid markets allow for considerably more risk management options. When examining liquidity, we look for two things:
1) Large average daily volume that is at least 20 times larger than our expected investment.
2) A wide variety of market participants.
Compare the variety of market participants between stock in a coffee shop conglomerate and coffee itself:
Coffee Shop Conglomerate
· Investors
· Traders
Coffee Beans
· Investors
· Traders
· Growers
· Processors
· Roasters
· Importers
· Exporters
· Buyers
There are quite simply more reasons for transactions to happen when you are dealing with the real goods of the underlying economy. If investors and traders seek liquidity and stop or reduce transactions, equity markets can grind to a near or complete halt. However, markets with other participants still need to transact in order to grow, move and use goods.
While liquidity in any market can dry up, these other participants often provide liquidity when you need it most.
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Acorn Seeks Deep End of Pool