Source/Contribution by : NJ Publications
Liquidity is a familiar tune that you would often come across. It is one of the most critical aspects and is behind most financial problems that people land into. Concurrently, it is also one of the most understated elements considered while investing, our focus is usually limited to the returns offered.
So, to begin with, let's understand what exactly is Liquidity.
Liquidity is the ease with which you can redeem your investment and get the proceeds in your bank account, the sooner it takes to reach in your hands, the more liquid it is.
On these lines, Cash and Real Estate can be considered as the two extremes of Liquidity, Cash being the most liquid and Real Estate on the other extreme end of the liquidity line, especially if it is a heavyweight property, that is a lot of value is attached to it.
However, there is a little deviation to the definition of liquidity. Along with the ease, an asset is considered liquid if the price of the investment isn't affected because of the sale.
In case of stocks and equity mutual funds, although you can redeem the investment and have your money fairly easily, yet stocks aren't considered as liquid assets, because of the volatility associated with them. Investment in equity with a short horizon can be risky because markets are volatile, the investment can even fall below the purchase price soon after investing, and you might even end up losing money.
Why do you need Liquidity?
Quite often we see, that a lot of people have most of their money stacked up in assets, which are illiquid and are ideal for long term investing, leaving them with negligible cash or liquid assets.
You must have heard about cases when properties are available at mouthwatering rates if the payment is made in cash or within a very short period of time. Investors redeem their fixed deposits prematurely, and pay heavy penalties on such withdrawals. Some sell their shares or Mutual Fund investments, which they had kept for their retirement, and the proceeds are lower than their investment value.
What leads these people land into such mess?
The answer is lack of Liquidity. These investors sell their investments at below market prices, to meet their urgent money needs like medical emergencies, job loss, etc.
You would not want to land into such a situation. Would You?
The solution to manage the mess is maintaining enough liquidity at all times. However maintaining Liquidity doesn't mean that you don't buy a home or invest in Mutual Funds or other Illiquid assets. You need these assets for your long term goals. Equity for instance has great return potential if you hold the investment for a long period of time.
The point is, you must ensure that you don't need to sell your long term investments for your short term money needs. You must have provided for resources to take care of the latter, this will enable you to hold on to the investment until the opportune moment when the asset has appreciated over time.
You need a mix of both, but you must provide for liquidity first So, before you invest in Equity or other Illiquid assets, having enough liquid assets is paramount, ensure that:
- You have created an adequate Emergency Fund. The Emergency fund should be such that it is quickly convertible into cash. And it must be enough to provide for at least 6 months to one year of your family's living expenses, so in case of loss of income, job loss, etc., you can survive without having to break your long term investments.
- You have yourself and your family covered with adequate insurances. Medical and hospitalization expenses in case an accident or a critical disease, can be huge and beyond the scope of your Emergency Fund, so you need adequate insurances, life and health, to ensure your long term investments are not compromised for such emergencies.
- Keep some money handy for one off expenses like washing machine repair or replacement, car service and repair charges, family weddings, etc. You can park surplus cash in liquid funds or short term debt funds also, to get a better return than saving accounts and at the same time these investments are liquid enough.
While making an investment decision, pay heed to the liquidity aspect of the product. Match your need with the liquidity offered. In some traditional investments, liquidity is very low, like a PPF or traditional endowment policies. You have to wait for decades to get your money back. Also note the process for cashing out, especially if the money is being kept for liquid needs like emergencies.
To conclude, returns can take you ahead in the long run, but make sure you have the necessary liquidity in place to savour those returns. Let not an emergency teach you a lesson. While you are evaluating investments, Liquidity plays a pivotal role and must be considered, along with Risk and Return.