There are two extreme situations of liquidity management in retail portfolios. Some tend to spend even their future income by swiping credit cards whenever they run out of cash, while others allow large amounts of cash to lie unutilised in their savings accounts. The choice of financial products is directly linked to the ability of investors to generate regular surpluses. Let us consider three situations.
The first involves structural limitations in cash management. You might have had the experience of handing out advances to your driver and household help. They suffer structurally from inadequate income to meet their routine need for cash. Lack of health insurance impacts them the most, as they find themselves borrowing routinely to treat health problems in their families. While some manage to get interest-free advances from their employers, many depend on moneylenders and pawnbrokers. Such households are unable to save since they do not generate regular surpluses (excess of income over expenses). They need insurance more than anyone else, and access to inexpensive credit.
Households where loans are taken from friends at the end of every month or credit cards are used to meet routine expenses are structurally-deficient, or where expenses routinely exceed incomes.
If you fall in this category, you need advice on debt and expense management, and alternative choices of employment to enhance your income. You are likely to be an edgy and anxious investor. Only after you reach a stable stage of having an excess of income over expenses will you develop the patience for long-term investing.
The second situation involves an uneven surplus or deficit. Some households comfortably generate surpluses for a few months, but have deficits in others. While they tend to save in the better months, they worry about unexpected need for money in the near future.
Analyse the unforeseen expenses. If it has to do with health, damage to your vehicle, or other assets and holdings, you need insurance. If it has to do with unexpected expenses on travel, entertainment, purchase of goods or services, education, etc, you need savings.
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If your routine income does not match your need for cash, there is a need to buffer it up with savings. You should prefer short-term investments to long-term ones. Behavioural adjustments that pre-empt you from spending money before you save can help. Starting a systematic investment plan, or asking your bank to transfer some part of your income to a deposit before you can spend the money will help to create savings.
You need a savings buffer to manage the unexpected cash need. You should choose such stable products as bank deposits, short-term debt funds, and have smaller amounts in products that have short-term risks.
The third situation involves households that routinely generate a surplus. If your income has moved up and your expenses are smaller in comparison, you are in a sweet spot. Your liquidity needs are the lowest, and you should have a plan to invest your savings for the long run. Your limited need for routine liquidity puts you in an ideal situation to invest in equity and growth assets that appreciate in value, but can be risky in the short term. Since you do not need routine liquidity, these product choices suit you well. These households need active management of the surplus so that the money does not remain idle.
It is important to understand whether the household is mostly in deficit (as in the first situation), in deficit or surplus (the second situation), or mostly in surplus (the third situation). Your requirement for financial-planning advice and choice of financial products should be linked to this categorisation. The first situation needs insurance and debt counselling, the second needs pre-emptive savings and budget management, and the third needs active deployment of savings. Wrong product choices routinely take place when households ignore their surplus-generating capabilities.
Agreeing to pay a large insurance premium to save on taxes and then reneging on payments are common when households with uneven surpluses choose products that need committed savings. Impatient investors in stock markets, sector funds and private equity are liquidity-seekers, who want their money back in a short span, since they have another need to fund. Match your ability to generate surpluses before you choose your investment products. That may be more important than where the market is, or where it is headed.
The writer is managing director, Centre for Investment Education and Learning. Views expressed are her own.