Definition of ‘Liquidity Risk’
The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Liquidity risk is typically reflected in unusually wide bid-ask spreads or large price movements (especially to the downside). The rule of thumb is that the smaller the size of the security or its issuer, the larger the liquidity risk.
Although liquidity risk is largely associated with micro-cap and small-cap stocks or securities, it can occasionally affect even the biggest stocks during times of crisis. The aftermath of the 9/11 attacks and the 2007-2008 global credit crisis are two relatively recent examples of times when liquidity risk rose to abnormally high levels. Rising liquidity risk often becomes a self-fulfilling prophecy, since panicky investors try to sell their holdings at any price, causing widening bid-ask spreads and large price declines, which further contribute to market illiquidity and so on.