First published on 10th December 2022
It’s been a rough year for those working in big tech. Thousands have already been laid off by Microsoft, Meta and Twitter. Just a couple of weeks ago, the New York Times reported that Amazon would beletting go approximately 10,000 employees, making it the largest job cuts in the company’s history.
Retrenchment could happen to anyone and it really sucks if you didn’t see it coming. It sucks even more if the severance package is crap.
It’s during times like this that you really wish you have done two things: (1) put aside an emergency fund, and (2) maintained a diversified portfolio that includes liquid assets in case of prolonged unemployment.
Good for you if both things are already in place!
Liquidity is about having ready cash and liquid assets that can be easily converted into cash. It is vital to your overall financial health.
This article explores the importance of liquidity, and its impact on your financial and investment decisions in the long run.
- What is Liquidity?
- Why Liquidity Matters
- Examples of Liquid and Illiquid Assets
- Profits Are Not Guaranteed
- Is Cash Really King?
- How Much Cash Do Mr Wow and I Hold? (A Case Study)
- Our Allocation at a Glance
- Selling in a Bear Market is Not an Option
- We Can Afford the Trade-off
- We Will Deploy the Cash at an Opportune Time
- What to Consider Before Deciding on How Much Cash to Hold
- Time Horizon
- Risk Tolerance
1. What is Liquidity?
There are two forms of liquidity — market liquidity and accounting liquidity — and they are closely connected.
Market liquidity refers to how quickly and easily an asset can be converted into cash (i.e. sold) without losing significant value.
When an asset has high market liquidity, its supply and demand are high. That means there are always people selling and buying it. Conversely, an asset that has low market liquidity is hard to sell and therefore cannot be turned into cash quickly.
Accounting liquidity refers to a company’s ability to fulfil its financial obligations with the cash and liquid assets it has.
When a company has high liquidity, it is a sign of good financial health as it means that the company can easily pay off debts that will come to due in less than a year.
2. Why Liquidity Matters
What applies to corporate finance applies to personal finance as well. People with low liquidity might default on their debt payments (e.g. mortgage and student loan) if they are hit by a major personal crisis such as loss of income. Hence, an individual’s liquidity gives you a glimpse into his or her financial health.
People with low liquidity might default on their debt payments if they are hit by a major personal crisis such as loss of income.
I heard a story from my dad recently when he was recounting the hard times many business owners faced during the 1997 Asian Financial Crisis. A few of his friends and associates were hit badly and one never recovered from it. Prior to the crisis, this friend ran three businesses and owned more than a dozen expensive residential and commercial properties. He lived in a beautiful bungalow and drove a Porsche 911. Then, as if overnight, he filed for bankruptcy and has been taking the bus ever since.
To cut the long story short, he was highly leveraged and had very poor liquidity. Thus, when his businesses started to fail one by one, he could not service his debts and things rapidly spiralled out of control.
My dad wrapped up the story by saying, ‘Many businesses were hanging by a thread during those dark days. Mine survived because I had a cash buffer. It’s very important to keep some ready cash at all times. Don’t lock all your money in illiquid investments.’
We often hear rags-to-riches stories that are incredibly inspirational. I think there are meaningful lessons to draw from riches-to-rags stories too. My dad’s friend is a a grim reminder that good times do not last forever. It’s like the weather. Sometimes, we get gloriously sunny days. Other times, we get strong wind, torrential rain, thunder and lightning — all at once.
Liquidity is about playing defensive and being in a state of preparedness to weather the storm. There’s no harm keeping some dry powder in the event of economic stress, whether you are in the wealth accumulation or preservation stage.
3. Examples of Liquid and Illiquid Assets
Whether you are a new or seasoned investor, it is important to bear in mind the liquidity of the different assets.
Liquid assets include (but not limited to):
- Cash and equivalents (e.g. savings accounts, money market accounts, time/fixed deposits)
- Government bonds
- Stocks, ETFs and REITs traded on major exchanges
- Physical gold
Illiquid assets include (but not limited to):
- Real estate
- Fine art
- Collectibles (e.g. stamps, antique furniture, classic cars)
- Private businesses
Note: More often than not, illiquid assets are tangible items. They tend to be high-priced and/or have a limited pool of willing buyers, so they take a long time to sell.
To find our more, read 4 Main Asset Classes: A Beginner’s Guide.
4. Profits Are Not Guaranteed
High liquidity doesn’t mean you will definitely make money. It only means that the asset can be converted into cash quickly. For instance, although the money in your time/fixed deposit is very accessible, you will forfeit the interest if a withdrawal is made before the maturity date, so there’s no gain there.
Similarly, stocks with high trading volume are very liquid, but there’s no guarantee that you will make a profit especially if you need to sell them ASAP. There’s every likelihood that you will lose money if the market condition is not favourable.
Stocks with high trading volume are very liquid, but there’s no guarantee that you will make a profit.
The ‘good’ news is, you can limit your losses (if any) by selling just enough stocks to free up the amount of cash you need. You don’t have to liquidate your entire equity portfolio if you only need a small fraction of it to tide you over a difficult period.
It’s a different story if you only have an illiquid asset like an expensive piece of art. Since you can’t possibly sell the piece partially, it’s either the whole thing or nothing at all, and that’s provided that you can find someone who is willing to buy it at a reasonably good price within a short time.
That said, an asset’s illiquidity does not affect its return potential unless we are talking about a fire sale. In fact, prices ofreal estate tend to remain stable and appreciate over a long time period. That’s why real estate is many people’s preferred long-term investment.
5. Is Cash Really King?
It should also be pointed out that maximum liquidity is probably not be the best idea. Cash itself is not risk-free, so it’s definitely no king.
Sure, keeping most or all your fortune in cash means you do not have to worry about market risk. You can sleep soundly at night knowing that your capital will be preserved, BUT have you forgotten inflation risk (i.e. the rising cost of goods and services)? If the interest earned in your savings account cannot keep up with the rate of inflation, it essentially means that your money is worth less and you are losing your purchasing power. Just look at 2022. Enough said.
6. How Much Cash Do Mr Wow and I Hold? (A Case Study)
So how much cash and liquid asset should there be in your portfolio? I’m afraid I don’t have an answer for you. Mr Wow and I are not financial consultants, so we don’t give personal advice. However, as a case study, I can tell you our allocation and how we came to our decision.
Our Allocation at a Glance
► Cash (Short-term): 15% (high-yield savings accounts, Singapore Savings Bonds and T-bills)
► Bonds (Mid-term): 25% (AAA credit rating Singapore Government Securities)
► Equities (Long-term): 60%
Note: We consider our home an unproductive asset, not an investable asset.
Yes, you can say that our entire portfolio is highly liquid. This allocation generates more than enough passive income to cover our annual expenses. Instead of spending the surplus, we usually reinvest it to create more passive income.
Some of you might be wondering why we keep so much liquid cash, especially since it doesn’t yield much compared to bonds and equities. Here are our reasons:
Selling in a Bear Market is Not an Option
Maybe because we were business owners, we are acutely aware of the importance of cash flow. Setting aside an emergency fund the equivalent of six months’ worth of expenses is, in our opinion, the bare minimum. To preserve our portfolio, we think it’s necessary to maintain a bigger safety net. This way, we will not find ourselves in the unpleasant situation of having to sell our stocks during a prolonged bear market (e.g. the dot-com crash, which lasted for more than two years). Our equity investments will remain positioned for long-term growth and we will simply draw on our substantial cash reserve.
We Can Afford the Trade-off
Of course, there is a trade-off between higher potential returns and peace of mind. All things considered, we think it’s an acceptable trade-off.
We are pretty conservative investors, so we are reluctant to risk our necks unnecessarily. As mentioned, our portfolio produces an annual surplus, which we usually reinvest. If this goes on, our net worth will continue to grow and outpace inflation most if not all the time. Given the case, we are perfectly fine to hold more cash for peace of mind, especially since the interest rates for high-yield savings accounts, time/fixed deposits and T-bills are pretty decent these days.
We Will Deploy the Cash at an Opportune Time
Being conservative doesn’t mean we won’t make a tactical move when an opportunity presents itself. Our stash of cash also provides us with the option to take advantage of market volatility and buy stocks at bargain prices.
Currently, we have a slightly larger cash holding than would normally be the case. This is mostly due to three consecutive years of underspending. We are hanging on to the spare cash for now as it’s not exactly the best time to pump more money into equities. Looking at the way things are, we think there may be a good buying opportunity in the near term.
This is not about trying to predict or time the market. Rather, it’s about striking a balance between generating more wealth and protecting what we have painstakingly built over the years. Wealth accumulation is different from wealth preservation. We are at the latter stage where ensuring that we will always have enough in retirement outweighs everything else.
It’s about striking a balance between generating more wealth and protecting what we have painstakingly built over the years.
7. What to Consider Before Deciding on How Much Cash to Hold
You should definitely consider two factors when deciding how much cash to hold.
Time Horizon
Figuring out your timeframe, i.e. when you will need your money, can help you decide how much cash you should hold. For example, if you need a sum of money for your child’s education in two years’ time, it may be best to stash it in cash and equivalents. This not only gives you easy access to the funds, but also ensures that you get back more than you put in (though not a lot since cash is low-yield). In contrast, there’s always a chance of making a loss if you invest the money in equities.
To make things easier, you could use the retirement bucket strategy and segment your money into three buckets: short-term, mid-term and long-term. The short-term bucket is basically your cash reserve, comprising one to three years’ worth of funds for near-term financial goals, living expenses and emergencies.
Risk Tolerance
Needless to say, cash alone will not help you accumulate significant wealth. Once you have set aside money for your short-term commitments, you could think about long term investing for passive dividend income and capital appreciation. When deciding how you should allocate your money, you need to consider your risk profile. Are you the risk averse sort or someone who is generally unfazed by market volatility and price fluctuations? If your risk tolerance is low, you might choose to hold more cash for a greater sense of security.
At the end of the day, your investments should not be causing you to lose sleep. Therefore, your risk tolerance has a considerable bearing on the type of investment approach you choose. It literally shapes your game plan. If you are not sure, it might be a good idea to speak to a financial advisor. Also, do read my article Portfolio Rebalancing for Beginners to learn how rebalancing your portfolio can help to mitigate risk.
Your risk tolerance plays a pivotal role in your game plan.
It is every investor’s dream to have a low-risk, highly liquid asset that gives great returns. Unfortunately, such an asset does not exist, so it’s up to each and every one of us to create a unique portfolio that caters to our goals and circ*mstances. The question is: How much do you value peace of mind?
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Tags: Financial Independence, Long-term Investing, Money Management, Retirement Planning, Wealth Building
