Investment Fallacies: Liquidity, liquidity, and not a drop to drink

Dear reader, A continuation of my series on Investment Fallacies.

“There’s too much liquidity in this market” is a refrain we hear all the time. But what does that really mean?

Liquidity can be thought of as the number of potential buyers, for any given security that you might want to sell. More buyers at a given price, means that there is consumer surplus, and you can raise prices. At a given market clearing price, however, there will only ever be 1 buyer and 1 seller, and they will transact at 1 price.

This, of course, only applies in efficient markets. Public markets do indeed tend towards efficiency regarding market microstructure, when considering the tick-by-tick clearing nature of the market. Thus, in some sense, there cannot ever be “too much” liquidity, only more people who would potentially want to buy your security at a given price.

What many people mean in reality is that there are a lot of people who are looking to purchase a given security, and are thus driving up prices higher than you think is “fair value”.

Another one is “there’s a lot of cash waiting to get into the market”. What people seem to forget is that for every buyer, there needs to be a seller. When someone buys a public market stock, someone is selling it: there is no net increase or decrease in the amount of “money” in the market.

There is an old joke about “how do you price an option?”…“you see how much someone is willing to pay for it”.

Again, to be fair, over time it is indeed possible for companies to issue new equity, or buyback and cancel equity. But really what most people mean is that there are a lot of people who would buy a security if it were cheaper: that they think the security is currently overvalued.

Yours Sincerely,
Henry Chong