What Is Liquidity?
Are your investments liquid or illiquid? When a holding is liquid, it simply means you can sell it anytime the market in which it trades is open for business, without losing your proverbial shirt in the exchange. If it’s illiquid, you cannot sell it relatively quickly, at least not for anything near what it’s worth.
Degrees of Liquidity
Cash and cash equivalents (such as checking or savings accounts) are the most liquid assets of all. All day, every day, you can almost always find somebody who will gladly give you something relatively worthwhile in exchange for your cash.
At the other end of the spectrum, some investments are highly illiquid, which means your ability to trade in and out of them whenever you please is strictly limited.
Finding Middle Ground
Between these extremes of highly liquid/illiquid holdings, you’ll find many of the investments that are most familiar to you. Mutual funds, exchange-traded funds (ETFs), stocks, and bonds are typically relatively liquid. They don’t flow in and out of your accounts as freely as cash, but even in turbulent markets you can usually sell them in a same-day transaction. (Mutual funds trade once daily at the end of the trading day. Individual securities and ETFs trade at prices that fluctuate throughout the day.)
It’s also worth noting, some investments can be more or less liquid, depending on how you hold them. Real estate is a prime example.
• If you own a piece of property directly, it’s relatively illiquid. Even in a stable market, it can take days, weeks, or months to sell your property once you’re ready to do so.
• A non-traded Real Estate Investment Trust (REIT) may be at least as challenging to unload whenever you please. Typically, the non-traded REIT’s board – not you – will decide when and how trading is permitted.
• A publicly traded REIT mutual fund or ETF is usually as liquid as any other mutual fund or ETF. Even though the fund’s underlying holdings may be relatively illiquid, you can usually sell your shares in that fund whenever public markets are open for business.
Liquidity: A Part of the Plan
Bottom line, cash (and cash equivalents) is the closest you come to having a completely liquid asset. This means it’s important to have plenty of it on hand to cover near-term spending needs. We recommend budgeting for expected expenses as well as the inevitable surprises.
That said, cash will only take you so far. It’s highly likely to lose rather than gain worth over time, as inflation eats away at its spending power.
As such, a degree of illiquidity – or the inability to convert an investment back into cash whenever you please – is essential to building wealth. It’s one of the risks from which investment returns are made.
We suggest managing liquidity as one consideration among many, achieving a balance that’s right for you. Maintain enough liquidity to ensure you’re never forced to sell a less-liquid investment just to get at the cash. Accept a degree of illiquidity in your soundly structured portfolio, to judiciously seek premium market returns over the long-term. Understand when illiquidity is essential to pursuing higher returns, versus when you’re just taking on extra risk, without much else to show for it.
If you could use some assistance making these determinations, please contact us. At ShankerValleau we primarily invest in mutual funds and exchange traded funds (ETFs), and we counsel our clients on their target cash levels as well as optimum solutions for this cash.
