Stock exchanges are platforms that allow investors to buy and sell stocks in a venue that is regulated and transparent. These exchanges enable investors of all stripes to trade stocks and other securities, potentially benefiting from a stock’s share price appreciation and dividend payments.
Stock exchanges help the stock market work, and are a big part of the overall economy. Understanding stock exchanges and how they work may help you how they affect you and your investments.
What Is a Stock Exchange?
A stock exchange is a marketplace where the shares of publicly-traded companies are bought and sold between investors.
Exchanges are generally organized by an institution or association that hosts the market, like the New York Stock Exchange or Nasdaq. These organizations and government regulators – like the Securities and Exchange Commission (SEC) in the U.S. – set up the rules and regulations of what companies investors can trade on a stock exchange.
If a company is “listed” on an exchange, it means that the company can be traded on that exchange. Not all companies are listed because each exchange regulates which companies meet their requirements. Companies not listed on the exchange are traded over-the-counter, or OTC for short.
Investors who want to buy or sell stocks commonly trade through an investment broker, a person or entity licensed to trade on the exchanges. Brokers aim to buy or sell stock at the best price for the investor making the trade, usually earning a commission for the service. Most investors will now use online brokerage firms for this service, paying little to no commissions for trades.
Historically, stock exchanges were physical locations where investors came together on a trading floor to frantically buy and sell stocks, like what you may have seen in the movies or on TV. However, these days, more often than not, stock exchanges operate through an electronic trading platform.
Major Stock Exchanges
10 Largest Stock Exchanges by Market Capitalization of Listed Companies
Exchange
Location
Market capitalization (in trillions)*
New York Stock Exchange (NYSE)
U.S.
$28.8
Nasdaq
U.S.
$25.43
Euronext
Europe
$7.15
Shanghai Stock Exchange
China
$6.52
Tokyo Stock Exchange
Japan
$6.25
London Stock Exchange
U.K.
$5.63
Shenzhen Stock Exchange
China
$4.29
National Stock Exchange of India
India
$4.53
Hong Kong Exchanges
Hong Kong
$3.97
Saudi Stock Exchange
Saudi Arabia
$2.86
*As of August 2024
Why Do We Have Stock Exchanges?
Stock exchanges exist because they provide a place for buyers and sellers to come together and trade stocks. Stock exchanges are also important because they provide a way for businesses to raise money. When companies issue stock to raise capital, investors will then trade the company’s shares on the stock exchange in which it is listed.
The individual stock exchanges set the rules for how stocks are traded. Stock exchanges are also regulated markets, which means that a government agency oversees the activity on the exchange. These rules and regulations provide a level of safety for investors and help to ensure that the market is fair, transparent, and liquid.
The stock market is made up of a network of different stock exchanges, including OTC markets, and the companies that are traded on these exchanges.
When you hear mentions of the stock market and its performance, it is usually in reference to a particular stock market index, like the S&P 500 or Dow Jones Industrial Average. However, the stock market is more than the specific companies that make up these stock market indices.
Generally, stock markets facilitate the buying and selling of shares between companies and institutional investors through initial public offerings (IPOs) in the primary market. Once a company has an IPO, the company’s shares are traded in secondary markets, like stock exchanges.
Stock Market Volatility
Volatility in the stock market occurs when there are big swings in share prices. Share prices can change for various reasons, like a new product launch or the most recent earnings report. And while volatility in the stock market usually describes significant declines in share prices, volatility can also happen to the upside.
Pros of the Stock Market
As mentioned above, the stock market allows companies to raise capital by issuing shares to investors. Raising money was one of the main reasons why stock issuances and trading began. It allows businesses to raise money to expand a business without taking out a loan or issuing bonds.
And because investors can own shares of companies, they can benefit from the growth and earnings of a business. Investors can profit from a company’s dividend payments, realize a return when the stock’s price appreciates, or benefit from both. This helps investors build wealth.
The relationship between stock markets, companies, and investors has arguably led to more economic efficiency, allowing money to be allocated in more productive ways.
Cons of the Stock Market
For companies, issuing shares on the stock market may be onerous and expensive due to rules and regulations from the stock exchanges and government regulators. Because of these difficulties, companies may be wary of going through the IPO process. Instead, they are more comfortable raising money in the private markets.
There are several potential risks associated with investing in the stock market. For example, the stock market is subject to market volatility, resulting in losses. Investors must be willing to take on the risks of losing money for the possibility of gains in the future.
Additionally, there is the potential for stock market fraud and manipulation by companies and investors, which harms individual investors, companies, and the economy.
A stock exchange is a marketplace where investors can buy and sell stocks or other securities, and where companies can list shares to try and raise capital. There are numerous stock exchanges, but the biggest in the U.S. are the New York Stock Exchange, and the Nasdaq.
Knowing the ins and outs of stock exchanges and how they influence the broader stock market may help you become a better-informed investor. Further, by learning about stock exchanges, their different rules, and their advantages and disadvantages, you may better understand the stock market as a whole. This may allow you to invest confidently and prepare for future stock market volatility.
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FAQ
What is the stock market?
The stock market is a collection of markets where stocks are traded between investors. It usually refers to the exchanges where stocks and other securities are bought and sold.
What are the benefits of investing in the stock market?
Some benefits of investing in the stock market include the potential for earning income through dividend payments, experiencing share price appreciation, and diversifying one’s financial portfolio beyond cash. Note, however, that there are significant risks associated with investing in the stock market, too.
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When a financial analyst rates a stock as overweight, it means that the analyst believes an overweight stock will likely outperform other stocks in its industry over the next six to 12 months. Conversely, if they describe a stock as underweight, they believe that it will perform poorly in the future.
It may be helpful to think of these terms as pointers: as if an industry specialist were saying, “You might want to overweight Stock X in your portfolio” or “maybe you should under-weight Stock Y.” These ratings are typically the result of factors in the news or pertaining to a specific company’s prospects. But the terms “overweight” and “underweight” also refer to a stock’s weighting in a relevant index or benchmark.
Key Points
• An overweight stock rating indicates that analysts expect the stock to outperform its industry peers within the next six to twelve months.
• The terms overweight and underweight also refer to a stock’s proportion in an investment portfolio, guiding investors on how much to hold.
• Different market indexes apply unique weighting systems, influencing how stocks are rated as overweight or underweight based on market capitalization or stock price.
• Investors should be cautious, as an overweight stock may not always lead to significant gains and could lead to portfolio imbalance if not managed properly.
• The context of both the market and individual portfolios is crucial when interpreting overweight ratings, emphasizing the need for careful investment decisions.
What Is an Overweight Stock?
As noted, an overweight stock is one that analysts believe will outperform others in its sector or market segment in the near future. Similarly, overweight stock is a moniker that may also describe a specific security’s weighting in a portfolio, and one that analysts think investors should buy more of – so, its meaning can be contextual in certain situations.
💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
Types of Ratings and Where They Came From
To understand stock ratings related to weight, it’s important to know that market indexes assign a weight to the investments they track to be sure that the index accurately reflects the performance of that market sector.
For example, the S&P 500® tracks 500 large-cap U.S. companies. The companies in the index — called the constituents — are weighted by market capitalization. A company’s market cap is calculated by multiplying the current share price by the total number of outstanding shares.
Companies in that index are weighted based on the proportion of the overall index their market cap represents. Other indexes may use a different weighting system. The Dow Jones Industrial Average, for example, tracks 30 blue chip companies and weights them based on stock price. Companies with a higher share price are given more weight than those with lower prices.
Because of these different weighting systems, it’s important to understand that an overweight to a particular stock with regards to one index may not be the same when it comes to another.
Overweight Stocks
When an analyst rates Stock X as overweight, it’s generally a positive sign. First, they believe Stock X is likely to outperform its benchmark index, or even the market as a whole, depending on market conditions, so investors should consider holding more of the stock.
Bear in mind that an “overweight stock” rating doesn’t necessarily mean that stock is a juggernaut. In a down market, being overweight could simply mean the company might not lose as much ground as its peers, or it might grow less slowly than its peers.
Underweight Stocks
When an analyst rates Stock Y as underweight, the analyst believes that Stock Y is likely to underperform its benchmark, and investors should consider holding less of this stock.
Equal Weight Stocks
When an analyst gives an equal weight rating to a stock, that simply means it’s in line with the overall benchmark. Again, when considering these ratings it’s important to keep in mind the overall context of the market, and what these ratings mean to analysts.
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Example of an Overweight Stock
A very simple example of an overweight stock could be when a stock, Stock X, is selling for $50, but experts and analysts think it’s undervalued and should trade for $75, it could be overweight.
Further, an overweight stock rating can be taken in two ways: First, that the stock will outperform its benchmark index and second that investors may want to take advantage of the increase in price.
When an analyst indicates their belief that a stock will appreciate, they may also state a potential time frame and price target for the stock. So, if Stock X is trading at $75 per share, and the company releases new earnings data that’s positive, an analyst might rate the stock as overweight, with a price target of $100 per share in the coming year.
💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.
The Downside of Weighting Stocks
One critique of this rating system is that no analyst, of course, can recommend how many shares investors should buy. It’s simply not possible for analysts to know whether Investor A’s portfolio might benefit from an additional 100 shares of Stock X, while Investor B might want to buy 1,000 shares of Stock X.
As a result, it’s incumbent on individual investor’s themselves to keep an eye on how relevant an overweight stock rating might be for their specific allocation. Buying more of Stock X could, in theory, create an imbalance and reduce a portfolio’s overall diversification. So while an overweight stock might be a good thing, an overweight portfolio usually is not.
How Can Investors Interpret Overweight Stocks?
At first glance, the terms overweight and underweight may seem more or less synonymous with “buy” and “sell” — in that case, why don’t analysts use these more straightforward terms?
In fact, the terms overweight and underweight do have a slightly different connotation than simply to buy or sell a security. Rather, the terms suggest a recommendation that a portfolio hold more or less of a particular position than an index or other benchmarks would suggest.
It may mean acquiring more, or selling some, of a particular investment. But it wouldn’t necessarily mean buying something new or selling all of a position. For example, if your portfolio has an allocation to tech stocks, and an analyst recommends overweighting one of those stocks, you may want to buy more of that company. Or you may not need more growth in your tech holdings, so you might look for an overweight stock.
Also, analysts aren’t always comfortable giving specific directions to buy or sell certain securities. The terms overweight and underweight are more like offering guidance: “Here’s what I think of Stock X or Stock Y. I’ll let the investor take it from here.”
In many cases an overweight or underweight recommendation might not be very useful for investors. For example, if an analyst recommends an overweight to a certain commodity but an investor’s portfolio doesn’t hold any commodities, this information may not have much bearing on their situation.
Can a Portfolio Be Considered Overweight?
Overweight can refer to a portfolio that holds more of a stock or other investments than it theoretically should. For individual investors, this might mean that more of a portfolio is allocated to stock than the investor intended.
For example, say an investor has a portfolio allocation in which 70% of its allocation is held in stock and 30% is held in bonds. If the stock market goes up, the proportion of the portfolio held in stock may grow beyond the 70% mark. At that point, the portfolio may be described as overweight in stocks, and an investor may want to rebalance to bring it in line with their initial allocation plan.
It may come as no surprise that the opposite of an overweight allocation is an underweight allocation. For example, if the stock allocation in the portfolio above fell below 70%, that allocation could be described as underweight in stocks.
The term can also apply in a narrower sense. For example, a stock portfolio could hold too much stock in one company, sector, or geographical region. In each case the holding could be described as overweight.
Professional fund managers may also use overweight to describe portfolios they work with that are off track with their index, including mutual funds, exchange-traded funds, and index funds. From time to time, a fund may get out of line with its benchmark index by holding more or less of an investment that index tracks.
For example, say an index fund is built to track the S&P 500. To track the index, fund managers will usually attempt to hold every stock in the index. Additionally, they will try to match the proportion of each individual company their fund holds to the index as well. So if stock A represents 5% of the original index, the fund will also hold 5% of stock A.
Some funds have a little bit of wiggle room in terms of how far they can stray from the index. Some might be allowed to hold more or less stocks if they think the stocks will outperform or underperform. When they hold more than the index, the managers are taking an overweight position. And when they hold less than the index, the managers are taking an underweight position.
The Takeaway
Overweight stocks are those that may be undervalued by the market. When an analyst gives a stock an overweight rating, broadly speaking it could be a good thing. If the analyst is correct, and the stock is indeed poised to perform better than its benchmark — maybe even better than the market as a whole — investors may want to buy that stock.
But the necessary caveat is that it all depends on context — the context of the market, and the context of an investor’s portfolio overall. You don’t want to buy a stock that could throw your allocation off, and make your portfolio overweight in a way that’s not ideal.
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For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.
FAQ
Is overweight stock good?
An overweight stock can be good for investors looking for a relative deal, but it may not be a good thing if the investor already owns shares of the stock.
What is the difference between overweight and outperform stocks?
Outperform stocks and overweight stocks are similar, and the terms are often used interchangeably. But generally, “outperform” may describe a stock that’s undervalued or expected to offer solid returns in the future, but perhaps perform not quite as well as an “overweight” stock.
What is the difference between buy and overweight?
On an analysts’ rating system, “buy” and “overweight” stocks are rated differently, with “buy” being a higher rating – though both ratings are positive.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.
Bond valuation is a way of determining the fair value of a bond. Bond valuation involves calculating the present value of the bond’s future coupon payments, its cash flow, and the bond’s value at maturity (or par value), to determine its current fair value or price. The price of a bond is what investors are willing to pay for it on the secondary market.
When an investor buys a bond from the issuing company or institution, they typically buy it at its face value. But when an investor purchases a bond on the open market, they need to know its current value. Because a bond’s face value and interest payments are fixed, the valuation process helps investors decide what rate of return would make that bond worth the cost.
Key Points
• Bond valuation is the process of determining a bond’s fair value by calculating the present value of future coupon payments and its value at maturity.
• Investors must consider the bond’s current price, which may differ from its face value, as it reflects market conditions and the issuing company’s creditworthiness.
• The valuation involves discounting the bond’s future cash flows using a realistic discount rate, which is essential due to the time value of money.
• Changes in interest rates significantly affect bond pricing; rising rates usually decrease bond prices, while falling rates can increase them.
• Investing in bonds can diversify a portfolio, as they tend to be less risky than stocks and provide a predictable income stream through fixed payments.
How Bond Valuation Works
First, it’s important to remember that bonds are generally long-term investments, where the par value or face value is fixed and so are the coupon payments (the bond’s rate of return over time) — but interest rates are not, and that impacts the present or fair value of a bond at any given moment.
To determine the present or fair value of a bond, the investor must calculate the current value of the bond’s future payments using a discount rate, as well as the bond’s value at maturity to make sure the bond you’re buying is worth it.
Some terms to know when calculating bond valuation:
• Coupon rate/Cash flow: The coupon rate refers to the interest payments the investor receives; usually it’s a fixed percentage of the bond’s face value and typically investors get annual or semi-annual payments. For example, a $1,000 bond with a 10-year term and a 3% annual coupon would pay the investor $30 per year for 10 years ($1,000 x 0.03 = $30 per year).
• Maturity: This is when the bond’s principal is scheduled to be repaid to the bondholder (i.e. in one year, five years, 10 years, and so on). When a bond reaches maturity, the corporation or government that issued the bond must repay the full amount of the face value (in this example, $1,000).
• Current price: The current price is different from the bond’s face value or par value, which is fixed: i.e. a $1,000 bond is a $1,000 bond. The current price is what people mean when they talk about bond valuation: What is the bond currently worth, today?
The face value is not necessarily the amount you pay to purchase the bond, since you might buy a bond at a price above or below par value. A bond that trades at a price below its face value is called a discount bond. A bond price above par value is called a premium bond.
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How to Calculate Bond Valuation
Bond valuation can seem like a daunting task to new investors, but it is not that onerous once you break it down into steps. This process helps investors know how to calculate bond valuation.
Bond Valuation Formula
The bond valuation formula uses a discounting process for all future cash flows to determine the present fair value of the bond, sometimes called the theoretical fair value of the bond (since it’s calculated using certain assumptions).
The following steps explain each part of the formula and how to calculate a bond’s price.
Step 1: Determine the cash flow and remaining payments.
A bond’s cash flow is determined by calculating the coupon rate multiplied by the face value. A $1,000 corporate bond with a 3.0% coupon has an annual cash flow of $30. If it’s a 10-year bond that has five years left until maturity, there would be five coupon payments remaining.
Payment 1 = $30; Payment 2 = $30; and so on.
The final payment would include the face value: $1,000 + $30 = $1,030.
This is important because the closer the bond is to maturity, the higher its value may be.
Step 2: Determine a realistic discount rate.
The coupon payments are based on future values and thus the bond’s cash flow must be discounted back to the present (thanks to the time value of money theory, a future dollar is worth less than a dollar in the present).
To determine a discount rate, you can check the current rates for 10-year corporate bonds. For this example, let’s go with 2.5% (or 0.025, when expressed as a decimal).
Step 3: Calculate the present value of the remaining payments.
Calculate the present value of future cash flows including the principal repayment at maturity. In other words, divide the yearly coupon payment by (1 + r)t, where r equals the discount rate and t is the remaining payment number.
$30 / (1 + .025)1 = $29.26
$30 / (1 + .025)2 = 28.55
$30 / (1 + .025)3 = 27.85
$30 / (1 + .025)4 = 27.17
$1030 / (1 + .025)5 = 1,004.87
Step 4: Sum all future cash flows.
Sum all future cash flows to arrive at the present market value of the bond : $1,117.70
Understanding Bond Pricing
In this example, the price of the bond is $1,117.70, or $117.70 above par. A bond’s face or par value will often differ from its market value — and in this case its current fair value (market value) is higher. There are a number of factors that come into play, including the company’s credit rating, the time to maturity (the closer the bond is to maturity the closer the price comes to its face value), and of course changes to interest rates.
Remember that a bond’s price tends to move in the opposite direction of interest rates. If prevailing interest rates are higher than when the bond was issued, its price will generally fall. That’s because, as interest rates rise, new bonds are likely to be issued with higher coupon rates, making the new bonds more attractive. So bonds with lower coupon payments would be less attractive, and likely sell for a lower price. So, higher rates generally mean lower prices for existing bonds.
The same logic applies when interest rates are lower; the price of existing bonds tends to increase, because their higher coupons are now more attractive and investors may be willing to pay a premium for bonds with those higher interest payments.
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Is Investing in Bonds Right for You?
Investing in bonds can help diversify a stock portfolio since stocks and bonds trade differently. In general, bonds are seen as less risky than equities since they often provide a predictable stream of income. Investors can consider bonds as an investment, and those with a lower risk tolerance might be better served with a portfolio weighted highly in bonds.
Performing proper bond valuation can be part of a solid research and due diligence process when attempting to find securities for your portfolio. Moreover, different bonds have different risk and return profiles. Some bonds — such as junk bonds and fixed-income securities offered in emerging markets — feature higher potential rates of return with greater risk. “Junk” is a term used to describe high-yield bonds. You can take on higher risk with long-duration bonds and convertible bonds. Some of the safest bonds are short-term Treasury securities.
You can also purchase bond exchange-traded funds (ETFs) and bond mutual funds that own a diversified basket of fixed-income securities.
The Takeaway
Bond valuation is the process of determining the fair value of a bond after it’s been issued. In order to price a bond, you must calculate the present value of a bond’s future interest payments using a reasonable discount rate. By adding the discounted coupon payments, and the bond’s face value, you can arrive at the theoretical fair value of the bond.
A bond can be priced at a discount to its par value or at a premium depending on market conditions and how traders view the issuing company’s prospects. Owning bonds can help diversify your portfolio. Many investors also find bonds appealing because of their steady payments (one reason that bonds are considered fixed-income assets).
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.
Photo credit: iStock/Tempura
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences. Fund Fees
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Liquid assets are any assets that can be easily and quickly converted into cash. In fact, people often refer to liquid assets as cash or cash equivalents, because they know that the asset can be exchanged for actual cash without losing value.
Here’s a closer look at the topic and how liquid assets can contribute to your financial wellbeing.
Key Points
• Liquid assets are easily convertible to cash, allowing quick access to funds without significant loss in value, essential for financial flexibility during emergencies.
• Common examples of liquid assets include cash in bank accounts, stocks, bonds, mutual funds, and money market funds, which can be readily sold for cash.
• Non-liquid assets, such as real estate and collectibles, require more time and effort to convert into cash, often leading to potential value loss during the process.
• Maintaining liquid assets is important for calculating net worth, applying for loans, and ensuring a business can handle emergencies or market fluctuations effectively.
• Building liquid assets involves creating an emergency fund with three to six months’ worth of expenses, allowing for better financial security and investment opportunities.
What Makes an Asset Liquid?
Liquidity means that you can readily access an asset as cash. While you might own any number of valuable assets (e.g., your home, retirement accounts, collectibles) and these can be considered part of your overall net worth, only liquid assets can generate cash quickly, when circumstances demand it. If you needed cash quickly, you likely would not be able to sell your home overnight to get money.
For an asset to be considered liquid, it must be traded on a well-established market with a large number of buyers and sellers. It also must be relatively easy to transfer ownership. Think: stocks, bonds, mutual funds and other marketable securities.
Generally, you can sell stocks and obtain cash readily. By contrast, you probably couldn’t sell your vintage watch collection that fast, and even if you could, there are a number of factors that might influence how much cash value you might obtain from the sale.
Worth noting: Although liquid assets (aka cash and cash equivalents) pose very little risk of loss, they also have little or no capacity for growth.
What Investments Are Considered Liquid Assets?
As you can see, the primary advantage of liquid assets is that they can be converted to cash in a short period of time. For example, stock trades must be settled within two days, according to Securities and Exchange Commission rules. Here, you’ll learn more about what are considered liquid assets.
Examples of Liquid Assets
Here are some specifics about what a liquid asset is.
• Stocks. Stocks are often considered liquid assets because they can be converted into cash when you sell them. Keep in mind, though, that the most liquid stocks might be the ones that many people want to buy and sell. You may have a more difficult time liquidating stocks that are in lower demand.
• U.S. Treasuries and bonds. These instruments are relatively easy to buy and sell, and these processes are usually done in high volume. They have a wide range of maturity dates, which helps you to figure out when you want to liquidate them. Because U.S. Treasuries are often considered relatively safe and dependable, the interest rates are somewhat lower and could be a good fit for investors who are looking to mitigate risk.
• Mutual funds.Mutual funds are pooled investment vehicles that hold a diversified basket of stocks, bonds, or other investments.
◦ Open-end mutual funds are considered more liquid than closed-end funds because they have no limit on the number of shares they can generate. Also, investors can sell their shares back to the fund at any time.
◦ Closed-end mutual funds, on the other hand, are less common. These funds raise capital from investors via an IPO; after that, the number of shares are fixed, and no new shares are created. Instead, closed-end funds shares can only be bought and sold on an exchange, and thus are considered less liquid than open-end fund shares because they’re more subject to market demand.
• Exchange-traded funds and index funds. Like mutual funds, exchange-traded funds (ETFs) and index funds allow individuals to invest in a diversified basket of investments. ETFs are traded like stocks, throughout the day on the open market, which makes them somewhat more liquid than index funds, which only trade at the end of the day.
• Money market assets. There are two main types of money market assets:
◦ A money market fund is a type of mutual fund that invests in high-quality short-term debt, cash, and cash equivalents. It’s considered low-risk and offers low yields. It is therefore thought of as a relatively safe vs. risky investment. You can cash in your chips at any time, making money-market funds a liquid investment.
◦ Money market funds are different from money market accounts, which are a type of savings account that’s insured by the Federal Deposit Insurance Corporation (FDIC).
• Certificates of deposit. If you have money in a certificate of deposit or CD, this might be considered semi-liquid because your money isn’t available until the official withdrawal date. You can withdraw money if you need it, but if you’re doing so before the maturity date, you’ll likely pay a penalty.
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What Assets Are Considered Non-Liquid?
There are, of course, many assets that are not easy to liquidate quickly. These assets typically take a relatively long time to sell or for the deal to close. You’ll get your money, but most likely not right away, and there may be time or costs associated with the conversion to cash that could impact the final amount. That’s why assets like these are considered illiquid or non-liquid assets.
Examples of Non-Liquid Assets
• Collectibles. Items like jewelry and artwork, as well as hobby collections like stamps and baseball cards, may be hard to value and difficult to sell.
• Employee stock options. While employee stock options can be a valuable form of compensation, they may also be highly non-liquid. That’s because employees must typically remain with a company for years before their options vest, they exercise them, and they finally own the stock.
• Land and real estate. These investments often require negotiation and contracts that can tie up real estate transactions for weeks, if not months.
• Private equity. There are often strict restrictions about when you can sell shares if you’ve invested in private equity assets such as venture capital funds.
Liquid Assets in Business
If you’re running a business, accounts receivable — the money you’re owed from clients — are often considered to be a liquid asset, because you can typically expect to be paid within one or two months of billing.
Any inventory you have on hand, such as office furniture or a product you’re selling, can also be considered liquid, because you could sell them for cash if need be. The liquid assets on your company balance sheet usually list cash first, followed by other assets that are considered liquid, in order of liquidity.
Having more liquid assets is desirable because it indicates that a company can pay off debt more easily. When businesses need to determine how cash liquid they are, they often look at the amount of their net liquid assets. When all current debts and liabilities are paid off, whatever remains is considered their liquid assets.
Are Retirement Accounts like IRAs and 401(k)s Liquid Assets?
Retirement accounts, such as individual retirement accounts (IRAs) and 401(k)s are not really liquid until you’ve reached age 59 ½. Withdraw funds from your account before then, and you may face taxes and a 10% early withdrawal penalty.
What’s more, you can hold a variety of assets inside retirement accounts. For example, if you hold a money market fund inside your IRA, that is a liquid asset. But you could also hold real estate, which very much isn’t.
Reasons Why Liquid Assets Matter
Other than the most obvious reason, which is that cash gives you a great deal of flexibility and can be essential in a crisis, liquid assets serve a number of purposes.
• Calculating net worth: To calculate your net worth, subtract your liabilities (your debt) from your assets (what you own, which can include your liquid assets).
• Applying for loans: Lenders might look at your liquid assets when you apply for a mortgage, car loan, or home equity loan. If your liquid assets are high, you may get better terms or lower interest rates on your loans. Lenders want to know that if you were to lose your job and/or your income, you would be able to continue to pay back the loan using your liquid assets.
• Business interests: Having liquid assets on your balance sheet is a signal that your business is prepared for an emergency or a market shift that could require a cash infusion.
Are All Liquid Assets Taxable?
While income is money you earn or receive, an asset is something of value you possess that can be converted to cash at some point in the future. While owning an asset doesn’t make it taxable, converting it to actual cash would, in most cases.
The IRS, or Internal Revenue Service, has many rules around how the proceeds from the sale of assets can be taxed.
The IRS considers taxable income to include gains from stocks, interest from bonds, dividends, alimony, and more. Gains on the sale of a home might be taxed, depending on the amount of the gain and marital status. If you aren’t sure whether income from the sale of an asset is taxable, it might be wise to consult a tax professional.
Is It Smart to Keep Cashing In Liquid Assets?
The point of maintaining a portion of your assets in liquid investments is partly for flexibility and also for diversification. The more access to cash you have, the more prepared you are to navigate a sudden change in circumstances, whether an emergency expense or an investment opportunity.
Having a portion of your portfolio in cash or cash equivalents can also be a hedge against volatility.
Thus, it may be worth keeping a mix of both liquid and non-liquid assets to help you reach your short-term financial goals as well as longer-term ones. And while cashing in liquid assets might be necessary, it’s also prudent to keep some cash on hand in case you need it. You may want to focus on gathering at least three to six months’ worth of expenses in the form of liquid assets as an emergency fund.
How Liquid Are You?
To figure out how liquid you are, make a list of all your monthly expenses, from rent/mortgage on down, including even your streaming service subscription. Then, make a list of all your liquid assets and investments (being careful to pay attention to the definition of liquid assets vs. illiquid assets, as it can be confusing).
Then, total all your monthly expenses, and compare that sum to the liquid assets in your possession.
Does your total savings cover six months’ worth of monthly expenses? If so, congrats! If not, you’re not very liquid. Don’t despair, though. There are ways to build up more liquidity by growing your emergency fund.
Where to Start Building Liquid Assets
As you start to build your liquid assets, first consider saving a cash cushion in the form of an emergency fund, which should be enough to cover any unexpected expenses that might come along.
Envision what you might need in the event of a crisis (e.g., a job loss, divorce, health event, and so on). In terms of how much to save in an emergency fund, aim to accumulate three to six months’ worth of expenses to cover basic bills, repairs, insurance premiums and copays, as well as any other personal or medical expenses.
One good way to build liquidity is to set money aside every week or month. Or you might have a set savings amount auto-deducted from each paycheck. You could keep the funds in a high-yield savings account to help them grow.
From there, you may consider opening a retirement account or a taxable brokerage account where you can invest in potentially more lucrative (but risky) liquid investments, such as stocks, bonds, mutual funds, and ETFs.
The Takeaway
Liquid assets are assets that can be converted into cash relatively easily — typically with little or no loss in value. Liquid assets can include cash in a checking or savings account, money market accounts, or marketable securities like stocks, bonds, mutual funds, and ETFs.
Liquid investments can play a surprisingly important role in your financial wellbeing. Having ready access to cash can help you pay off debt, cover a crisis, or be able to invest in new opportunities.
Having the right banking partner can help you keep your cash secure and earning interest.
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FAQ
What’s the definition of a liquid asset?
A liquid asset is an asset that is readily converted into cash, such as money in the bank, stocks, or a certificate of deposit (although you might owe a penalty when you liquidate it).
What does non-liquid asset mean?
Non-liquid assets are resources that can’t be quickly converted to cash, such as real estate, employee stock options, or collectibles (such as artwork or jewelry) that would have to be sold, which can take time and the price may fluctuate.
Is a 401(k) considered a liquid asset?
Retirement accounts, such as a 401(k) are not really considered liquid until you are over the age of 59 ½. Before that age, you would face a 10% early withdrawal penalty, as well as taxes, meaning you would take a loss on the value.
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