When you visit a local cafe to buy a cup of coffee, you’ll have several quick and easy payment options which allow you to get your morning caffeine. You might get some cash out of your wallet or the ATM, or use a credit card, or even write a check if you’re so inclined.
Chances are you have other assets beyond these payment methods, but your friendly neighborhood cafe won’t be inclined to accept them. If you walk up to the barista and try to buy your drink with a stock certificate or a piece of artwork, it makes the transaction a lot more complicated.
This, in a nutshell, is the concept of liquidity, or how quickly an asset can be bought or sold without a significant change to its price. For some assets, this can be done rapidly and efficiently; for others, more time, deliberation, and uncertainty is involved.
Understanding liquidity is an important part of creating a balanced portfolio that fits your personal circumstances. In this blog, we’ll be exploring the concept of liquidity and how it can affect your investment decisions.
Liquid and illiquid assets
Liquid assets have a known value, allowing a purchase or sale to be done quickly. Cash is considered to have the highest liquidity, since it is a universally accepted method of payment, can be exchanged for goods and services, and can be used for purchases without any dickering over valuation.
Other assets are considered liquid since they can be quickly sold and converted to cash if need be. Some examples include government bonds, shares in publicly traded companies, and exchange-traded funds.
Illiquid assets are any investments that are more challenging to buy or sell without having a significant impact on their price. These transactions also tend to take longer since they involve negotiation over the value of the asset. Illiquid assets include real estate, private equity investments, some bonds (such as municipal bonds), and collectibles like art or antiques.
What affects the liquidity of assets?
There are numerous factors affecting the liquidity of assets, including:
- Market size: When an asset is traded on a large and active market, such as a major stock index, it helps guarantee more liquidity since there will be a large number of people willing to buy or sell the asset. Assets that are available in less active markets with a smaller pool of participants will have less liquidity.
- Data: Assets with specific terms and conditions about how they can be bought or sold, as well as detailed information on factors like price history and financial performance, are easier for investors to compare and trade, and therefore more liquid.
- Accessibility: Liquid assets are typically traded with high frequency during regular market hours, and may be divided to make them accessible to a greater range of investors. This makes them easier to trade compared to illiquid assets, which have more limited opportunities for purchase or sale (as well as higher transaction costs, since they often require intermediaries to be involved in negotiations over the transaction).
How can I manage liquidity risk?
Liquidity risk refers to the possibility that an asset can’t be bought or sold at a reasonable price, which in turn means that you might be stuck with the investment and unable to convert it to its fair value in cash. While this risk is higher with illiquid assets, it can also happen with more liquid assets such as stocks and bonds if market stress, an economic downturn, or negative news about a company’s stock makes investors more cautious about buying or selling these assets.
Just as your investment portfolio should have a diverse range of investment options, it should also strike the right balance with liquidity. This strategy helps avoid a concentration of your investments in either liquid or illiquid assets.
Having at least part of your portfolio dedicated to short-term investments that can quickly be converted to cash, such as government bonds, ensures that you can quickly tap into the value of some of your assets. Some investments, such as ETFs and mutual funds, offer liquidity management tools to help ensure that they can meet redemption requests from investors.
What should my portfolio’s liquidity mix look like?
Deciding how much of your portfolio should be invested in liquid assets will depend on your financial goals, as well as your risk tolerance. Naturally, these will vary for each client.
If you plan to access your funds frequently, or have a specific time when you know you’ll want to do so, your portfolio should have higher liquidity. For example, an investment portfolio such as a 529 plan to save money for a child’s higher education expenses should have high liquidity, since you’ll need to access this at a known point to pay for tuition bills and other expenses.
Rebalancing your portfolio is an important part of liquidity balance. While a retirement portfolio is well-suited for illiquid assets due to its long time horizon, you’ll want to increase the liquidity of this portfolio as you grow closer to the date you’d like to start using these savings. You should also be comfortable with the amount of funds you can easily access through an emergency fund or other options, since market volatility can limit your ability to get a fair price on liquid assets.
Working with a financial advisor can help you find a liquidity strategy that fits your goals. Grey Ledge Advisors has five investment strategies (Capital Preservation, Conservative Income, Balanced, Growth, and Aggressive Growth) designed to suit your circumstances and access your assets when you need them. Contact us today by calling 203-453-9075 or using our online contact form.