In the finance world that never sleeps, reams and reams of data regarding investments of all kinds circulate each and every day. The words large cap growth, value, mid cap, & small cap add to the constant flow of investment jargon. Informed investors know exactly what a largely capitalised stock is, and conversely, a small cap (for short) stock. For those unfamiliar with the terms, very large publicly traded corporations are called large capitalisation companies because the market value of their shares on any given day times the number of outstanding shares held or floating in the marketplace total in excess of $5 billion dollars.

As an example, American International Group has a market capitalisation of $155 billion dollars. Divide that very large group of zeros by its closing price today (November 12, 2003) of $59.58 per share gives us about two and a half billion shares more or less out there in play to buy or sell, 24/7. Add the reputation this company enjoys, and that employs more people globally than the entire residency of Bermuda, and you have total liquidity. In just about any capital market, day or night, a buy or a sell in AIG can be transacted.

In contrast, a small capitalisation company (market cap under one billion) may have only 50 million shares outstanding. In this example, if insiders and executives own 15 million shares (owning restricted stock if you are an executive is often mandatory to keep the job) then the number of shares readily available to the free market is quite small. Smallness in number of shares may also accelerate volatility and other problems, such as lack of liquidity, the ability to buy or sell at will. The old axiom, that a perfect market is formed only when a willing buyer and a willing seller reach a price that is beneficial to both, is still true but one adds 'move rapidly' to the equation.

Liquidity refers to a capital market's ability to handle large volumes of trading in any stock without significant price swings. Major investors such as mutual fund managers monitor this issue closely because they tend to take large positions when they purchase a selected stock, not wanting this move to drive up the price precipitously. Small investors care about liquidity because they don't want to place an order to sell only to see large fluctuations downward. Or experience the situation in an illiquid or thinly traded market such as Bermuda, where sufficient buyers to absorb sell positions may take days to accumulate.

What if a theoretical stock market was set up where everyone wanted to sell their shares, but no one came to buy? Thinly traded stocks can be more susceptible. In the real world, it may happen to any stock under value pressure. In most stock exchanges, market makers (very large financial institutions or brokerage type firms) are duty bound to meet the needs of those they are responsible for and contract to be on the other side of the equation. Even as recently as the 1987 stock market crash, several Makers went bankrupt trying to prop up free falling share values. But make a market they must, and they make money from buying shares at a lower price than they sell them. The more actively a share is traded, the better the market and the bid / offer spread. Market makers generate more money in actively traded shares, although since decimal pricing, profits have become increasingly stressed.

The new form of buying and selling - electronic exchanges do not use physical market makers. Their process works by matching buyers to sellers in a best execution format. However, what happens to share value when there are very reluctant buyers? The debate about the best method of trading carries on.

It follows then that liquidity in an investment is the ability to sell out and get your cash back. US Treasuries are classified as the most liquid, followed by large cap securities (both bonds and equity components), then mid-cap, small cap, micro-cap, penny stocks, etc. Liquidity is also determined by quality and trading volume of different security classes and companies. Mutual fund managers must discount illiquid stocks when computing NAV (net asset value); analysts may normally discount the market value of illiquid securities by as much as 25 percent.

Shortsellers short thinly traded stocks by borrowing the shares from a broker during a market pop, then shorting them as they decline in value. Sometimes the plays don't play out, and the investor gets caught in a short squeeze trying to find enough illiquid shares to replace those borrowed. Too many traders chasing too few shares drives the purchase price above the shortsell in a painful culmination of volatility.

Financing for financially sound companies is harder to obtain when small cap stock may be employed as part of the collateral; the concern being that it may be difficult to liquidate. Today, it is hard to imagine a company CEO such as Bill Gates begging any bank for a loan. Yet Microsoft was once a very small very iffy - on the success side - venture. Some of you may remember the high flyers from yesteryear, names such as Rambus, Medscape, PlanetRX, rising to euphoric heights then crashing to the ground. For every successful large cap company today (small caps do grow up) there are probably ten to twenty little companies that never reach that zenith.

Stocks - no matter how well they performed - at some point, you may still want to be able to get your money back when you need to. Knowing when to hold and when to fold, that's the idea. If the stock is illiquid, the question is, can you when you want to? Planning for life stage events in advance anticipates liquidity issues when investing for the future.