BS Primer: What is liquidity and why does it matter?

What is Liquidity?

Liquidity explains the extent to which an asset can be converted into cash without significant loss of value. You may perceive it as an ability to realise the maximum value of an asset by purchase or sale without impacting the price of the asset. From an investment point of view, liquidity relates to the ease with which an asset can be bought or sold to meet the urgent need of cash. Of all the asset classes, cash happens to be the most liquid asset. Highly-traded stocks is yet another asset class which can be regarded as fairly liquid; because these can be converted into cash quickly and conveniently due to availability of a buyer.

Assets like real estate might not be easily convertible into cash. In case an investor has tied up a major chunk of his wealth in real estate, he/she may face difficulty in harnessing its full value in times of need.  Liquidating assets like thinly-traded stocks and certain debt instruments can become tough during economic crisis without losing a great deal of money.

Why liquidity is important?

Liquidity is an essential concept that many investors need to understand so as to increase the success rate of their financial plans like retirement or higher education. It is agreeable to park some of the money in illiquid assets to earn higher long-term gains. For that to occur, you have to ensure that there are no redemptions during the investment horizon and you stay invested till you find a right price or a right buyer.

However, it is vital to keep some of your wealth in assets that are highly liquid. There are some assets which seem liquid but cannot be withdrawn without loss of value. Think about a bank fixed deposit (FD) wherein your money remains tied up for a specified period of time. You would not be able to withdraw the money before maturity without facing hefty penalties. At this juncture, it becomes important to decide asset allocation wisely keeping in mind all kinds of financial goals.

When you are busy investing in high-return generating assets, don’t forget to consider the liquidity aspect. Creation of an emergency fund is the first thing that you need to do in this regard. It should have enough money to support your six months’ worth of personal expenses. Additionally, ensure that maturity of goals matches with that of the instrument chosen to finance them. Using debt funds for long-term goals may not be appropriate. Similarly, equity funds should not be used to achieve short-term goals.

How to incorporate liquidity in investing decisions?

Liquidity and profitability are conflicting concepts. While the former asks you to save money in safer havens, the latter demands investment in risky havens to increase overall returns. Developing an investment portfolio around these guidelines may become challenging at times. However, you need to look at money management from a holistic perspective. But stacking loads of cash in savings bank account need not be the only way to achieve liquidity. There are other ways to ensure liquidity while earning decent returns simultaneously. 

Liquid funds can be a prudent way to ensure a liquid portfolio. These are a type of mutual funds which are used to invest money for short-term horizons say from six months to one year. In addition to quick withdrawal and safety of capital, these funds deliver returns higher than a savings bank account. You may use liquid funds to create an emergency fund. Ensure that your investing decisions are aligned to your short-term and long-term goals. Look for alternative sources of wealth that can be used to satisfy your liquidity needs.

The Bottomline

While choosing an asset for liquidity needs, ensure that it offers easy and quick withdrawal. Moreover, try to avoid unplanned exits to prevent loss of returns. You may also invest in high-rated bonds for achieving liquidity.

(Author is the founder & CEO of ClearTax)