What does liquidity risk refer to?

Prepare for the Principles of Investment Exam. Study with flashcards and multiple choice questions, each question has hints and explanations. Get ready for your exam!

Liquidity risk refers to the possibility that an investor may not be able to quickly sell an investment without significantly impacting its price. This can occur in situations where there is a lack of market participants or when the asset is not actively traded. An investment can be illiquid if it is not easily convertible into cash or if it takes a considerable amount of time and effort to sell it in a favorable market. In contrast, options that describe losing money on investments, market fluctuations, or a company's financial instability pertain to different types of risks—specifically investment risk, market risk, and credit or financial risk—rather than liquidity risk. Thus, understanding liquidity risk is crucial for investors who want to ensure they can access cash when needed without incurring substantial losses.

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