Understanding Liquidity

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In the simplest terms, liquidity risk refers to the likelihood that an investment won’t have an active buyer or seller when you are ready to buy or sell it. Therefore, you will be stuck holding the investment at a time when you need cash and can cause you to take massive losses.

Liquidity poses a significant threat to investors’ financial well-being, therefore we wanted to discuss what liquidity risk is.

One of the reasons for the losses suffered by financial firms during the Great Recession was the fact that these companies owned illiquid securities. When they found themselves without enough cash to pay the day-to-day bills, they went to sell these assets but discovered that the market had dried up completely.

As a result, they had to sell at any price they could get.

On the upside, there is an opportunity with liquidity risk because other companies and investors that were flush with cash were able to buy distressed assets. Some of these “vulture” investors made a killing because they had balance sheets that could support holding non-liquid investments for long periods of time.

To compensate for liquidity risks, investors often demand a higher rate of return on money invested in illiquid assets, especially private placement deals.

Types of Liquidity Risks:

Bid/Offer Spread Widening

When an emergency hits the market or an individual investment, you may see the bid (buyer) and ask(seller) spread wider apart so that the market has a difficult time matching up buyers and sellers.

Example, you own Main Event Entertainment [JSE: MEEG] shares, you need the cash and ask for J$6.00, but the highest bid is J$ 5.00, you will have difficulty gettings funds as you either take the loss and sell at J$5.00 or wait and hope it goes to J$6.00 in the time frame you want!

Inability to Meet Cash Obligations When Payment Is Due

Puerto Rico bonds holders, you know what we are talking about here. This is the investment equivalent of defaulting on a debt. If a company has $100 million in bonds that reach maturity, it is expected to pay off the entire $100 million balance by the maturity date.

Most of the time, businesses refinance this debt. But what happens if the debt markets aren’t working and are unable to borrow money? In that case, if the company couldn’t come up with the whole $100 million, it could be hauled into bankruptcy court even if it is highly profitable. You would find yourself locked into what could be years of legal workouts due to the firm mismanaging its liquidity risk.

Inability to Meet Funding Needs at an Affordable Price

This is when it is impossible for a company or other investment to raise enough money to function correctly and meet its needs at a price that is economical. Wal-Mart Stores, Inc., for example, is one of the biggest and most profitable companies on the planet. It has tens of billions of dollars in debt to optimise the company’s capitalisation structure.

If the markets went haywire tomorrow and Wal-Mart could no longer borrow at 6% and investors instead demanded 30%, it would make no sense for the company to issue bonds. In effect, the market’s liquidity would have dried up entirely and the stockholders of Wal-Mart would have to worry about the company coming up with enough cash to wipe out all of its debt.

 

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Are IPOs the New Black?

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The Jamaican financial market went from one to two companies listing on the market each year to approximately ten for 2018. With so many companies choosing to raise funds on the stock market instead of going to the bank for a loan to expand their business, investors are left wondering which IPOs are worth considering.

An initial public offering, known commonly as an IPO, marks a pivotal moment in the life of any company. IPOs have played  a significant role in getting more and more Jamaicans interested in the stock market and also saw a record number of companies choosing to go public in 2017. Gone are the days of, “only the rich can invest”; investments and financial literacy is an everyman game.

With the government of Jamaica offering very attractive incentives for companies to list, they provide small and medium-sized enterprises (SMEs) a chance to grow which in turn benefits the economy providing jobs and promoting an overall healthy economy which is always a good thing.

However, there’s another way an IPO can go, and it’s nowhere near as glamorous or champagne-worthy as the scenario mentioned above. While there are some genuine gems in the market, there are also some cubic zirconias in the mix too. These cubic zirconias naturally become placeholders on Jamaica Stock Exchange.

IPOs tend to promote trading not necessarily investing. While the terms are used interchangeably, for this article, trading refers to the buying and selling of stocks based on price alone while investing relates to choosing a company based on fundamentals and thinking long-term. Not saying trading is the evil step child, however creating wealth requires the right combination of both.

Sometimes, it may be hard to figure out which IPOs are the gems, cubic zirconia or diamonds in the rough just waiting for the opportunity to shine.

 

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Callable Bond

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A bond where the issuer has the option to redeem the bond prior to the redemption date.

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Investing Techniques for Beginners

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One of the most common questions that financial advisors get asked is whether or not now is a good time to buy stocks. The answer is yes, as long you are buying reputable companies with proven track records. No one can truly predict what will happen next on the market and it is never a good idea to try and do so. SSL recommends investing for the medium to long term in securities that display the least amount of volatility in markets. To determine the volatility of securities, analysts employ a technique called the Dollar-Cost Averaging (“DCA”).

According to Investopedia, the DCA is the buying of a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high. Investors must remember that all investments carry with it a level of risk therefore there is no technique that will guarantee that an investor won’t lose money on investments. Financial advisors favour the DCA technique of investing as it does not require a lump sum of money to begin with, but rather, encourages regular deposit of the same amount over time.

To understand this method further, we can illustrate how this technique materializes. Let us assume that Matthew decided to invest $10,000 in Apple on the first day of the month for the next three months, without the restrictions of trade fees, no minimum amount and purchasing only whole number shares. One the first month, the share price was $100, on the second, $95, and on the last month, $105. When the price increased, Matthew was able to purchase less shares with the same fixed investment amount. The opposite also held true, when the price fell, he was able to buy more shares with the same amount of money. In this example, Matthew purchased 300 shares at an average cost of $100. Given that the current price is $105, the original investment of $30,000 would now be worth $31,500.

If the investor had invested all $30,000 in one of those months instead of spreading the cost across three, the market value of the portfolio could either be higher or lower than the $31,500, subject to the month of investment. Since no-one can accurately predict the future share price of stocks, and time the market, DCA is a safer alternative strategy used by persons worldwide to hedge their risk in an attempt to lower their average price per share. This technique   eliminates the assumption that investors must have a large lump sum of money to invest and yields to more conservative, low income earners.

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Spread

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The difference in yield between different types of bonds, for example between government bonds and corporate bonds. Also referred to as yield spread.

 

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Underlying Security

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The shares, other security, or index, on which a derivative instrument is based.

 

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Tender

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Tender is a method of issuing securities whereby investors are invited to bid, subject to a minimum price. The allocation of the securities is made according to the prices bid.

 

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Return on Equity (ROE)

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Return on Equity is a method of valuation of company accounts which can determine how a company is spending its money, calculated by dividing a company’s net income by its stockholder equity.

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Chartism

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Chartism is the study of historical market data to determine trends and to try to predict future movements.

 

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Follow by Example: Learn from Experienced Investors

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There is no set method as to how one should invest. However, based on the recent decline in market prices, why not take a page out of the more experienced investors book?

What would they do in this situation?

Investors such as Ben Graham, Peter Lynch and Warren Buffett have been around for a while. They have experienced market crashes before but have also made significant wealth from investing.

The Conservative Investor

Ben Graham made his investment decisions mostly on the financial analysis of stocks. Graham focused on safe investments and was not much of a risk taker. He preferred to invest in stocks when the market price is below the company valuation to gain significantly if the market price should increase but in the case where the prices fell there would be some cushion for the stock.

The Aggressive Investor

Peter Lynch, on the other hand, is the complete opposite. His investment decisions are based on market sentiment. Additionally, he was a long-term investor and was not bothered by market corrections.

Lynch lived by several investment principles, namely:

(a)    Be aware of the stocks in your portfolio

(b)   Do not predict interest rates or the economy

(c)   Give yourself time to realise which companies are exceptional and which are not

(d)   Identify and purchase stocks where the company’s management is strong

(e)   Adapt to changes and do not make the same mistake twice

(f)    Know why you hold, sell or buy a stock

The Moderate Investor

With a net worth of US$89 billion over a career spanning over 70 years, Warren Buffett is one of the most respected and well-known investor in the US. Buffett prefers to invest in stocks with moats. Meaning the company’s ability to stay ahead of its competitors to continue making profits and increasing market shares. Buffett describes events in the market such as market correction as a positive for investors as it is a perfect opportunity to stock pick and takes advantage of low stock prices.

Which one are you?

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Market Impact

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Market impact is a measure of each trade’s average execution price versus the volume weighted average price of the stock for that trading day. It is thus a measure of how the size of the order affects the price at which it is executed.

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Flotation

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Flotation is the first issue of shares to the public in a company new to the stock market. If you liked this article and want to read other great stories, try our Archives. Also if you are new to investing you can try our Investment Basics Blog.

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Blue Chip

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Blue Chip is the name used to describe companies that are perceived to be high quality.

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Barbell Portfolio

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The Barbell Portfolio is a portfolio of bonds which is concentrated in short and long-dated bonds with little or no exposure to intermediate maturity bonds.

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Ticker Symbol

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The Ticker Symbol is an abbreviation used to uniquely identify publicly traded shares of a particular stock on a particular stock market. A stock symbol may consist of letters, numbers or a combination of both.

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Dividends

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Dividends are the part of a company’s profit after tax earnings which is distributed to the shareholders in the form of cash or shares.

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Fundamental Analysis

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Fundamental Analysis is an analysis of a company taking into account all the factors that affect its cash flow, profits, business, the industry it operates in and the economy in general.

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London Interbank Bid Rate – LIBID

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London Interbank Bid Rate – LIBID is the interest rate at which prime banks will offer to take funds on deposit from other banks in the London Interbank market.

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Over Subscription

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Over Subscription is when more applications are received than there are shares for an offer. In this event, applications are usually scaled down pro rata.

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Federal Reserve Board

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The Federal Reserve Systems’ Board of Governors that oversees Federal Reserve Banks and establishes monetary policy in the US.

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