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Knowing liquidity in equity

india Updated: Oct 14, 2007 22:32 IST
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Investors encounter various situations while making investments and some of these can present a completely different experience for them. High amount of liquidity (more funds chasing stocks in the market) is one such area where investors need to be alert and active as it can impact the way in which their equity investments perform.

Presence of high liquidity is a situation that has been witnessed in the Indian markets over the last few years. An individual investor can tackle the situation by understanding the points given below.

Sources

The first point to consider is the source from which the entire liquidity has come. This can happen in various ways as the money can come from local mutual funds or it can be from foreign institutional investors (FIIs) or it could even be from insurance companies and pension funds. By looking at the source of the liquidity one can also get an idea as to how this factor will play out in the future considering the nature of the flow.

For example, if the liquidity has been created by local mutual funds, then looking at the cash component that these schemes hold in their portfolio, one can get an idea to the extent to which they can continue to influence the flow.

Sustainability

The most important thing as far as the flow of funds is concerned is whether this can be sustained over a period of time going forward. If this is just a one-off case or a small time event, then the impact of the flow will also be restricted to this time period.

But if this can be sustained, then liquidity as a factor in evaluation of the investment becomes a very important point for the investor to consider.

The nature of the flow will also play a role in knowing whether this is sustainable or not and if this is not sustainable, then the downside should also be factored in by the investor.

Distortions

Liquidity has the ability to completely distort the picture as far as the investment of an individual is concerned. This can result in a situation where the share price suddenly shoots up resulting in a position where expectations get distorted.

Investors suddenly begin to expect this kind of sharp rises and a high return from their investments, which may not always happen. This can also lead to a lot of disappointment for many.

Sharp fall

The reason for a rise in the share price of a company has to be considered carefully because if this is just on account of liquidity factors without adequate backup of performance, then the reverse can also happen as suddenly as the rise.

This means that if the liquidity suddenly dries up, then the investor can find that the price will plunge back to where it came from or even lower due to fear overtaking them, and this is precisely what happens in lots of small counters.

A liquidity flow backed by adequate fundamentals is a better situation for the investor even if the price falls.

(The writer is a Certified Financial Planner)