What is liquidity risk?

Liquidity risk refers specifically to the challenge faced when attempting to sell an asset quickly without incurring a significant loss in its value. This situation often arises when there is insufficient demand for the asset, meaning potential buyers are few or unwilling to pay a fair price. When liquidity is low, the seller may have to accept a lower price, thus realizing a loss compared to the asset's market value at a different time when conditions are more favorable.

This concept is critical for investors and financial planners because it influences investment strategies and asset allocation decisions. Understanding liquidity risk helps individuals manage their portfolios effectively, ensuring access to cash when needed without facing detrimental financial effects.