What is the role of liquidity in investment selection?

• A. Liquidity affects only credit risk.
• B. Higher liquidity increases price volatility.
• C. Liquidity refers to how quickly and cheaply an asset can be bought or sold; higher liquidity reduces transaction costs and the risk of forced sale.
• D. Liquidity is irrelevant for most investors.

Answer: (C)

Liquidity is about how quickly and cheaply you can buy or sell an asset. This matters in investment selection because it directly affects trading costs and how easily you can exit a position when you need cash or want to rebalance. Highly liquid assets have narrow bid-ask spreads and low price impact, so entering or exiting positions is cheaper and faster and the risk of being forced to sell at a bad price is reduced. Illiquid assets can require large price concessions, higher costs, and longer times to find a buyer, increasing liquidity risk and limiting flexibility in managing the portfolio. So the key idea is that liquidity reduces transaction costs and the risk of forced sale, while its absence increases those costs and risks. Liquidity is relevant for most investors, not just a few; it does not inherently increase price volatility, and it is not limited to credit risk.