Let’s start with the basics: What is liquidity? The simplest definition is the ability to convert an asset to cash. But not all assets are created equal. Some can be sold and converted to cash immediately while others require more planning. By this definition, cash itself is the most liquid part of your portfolio while things like your home are significantly less so.
But what is the purpose of having cash or cash-ready investments in your portfolio? While investing in the long-term and generating higher returns is great (and necessary for success), it is important to be prepared for emergencies. What if you lose your job? What if there is an expensive home repair not covered by insurance? According to Yahoo Finance, the U.S. Bureau of Labor Statistics found that the average period of unemployment in 2023 was 20 and 1/2 weeks, or almost 5 months. That is why the standard rule of thumb is to have three to six months’ worth of living expenses in the bank. But there are many sources of liquidity. Let’s explore some.
As we’ve established, cash is the most liquid piece of your portfolio. But cash doesn’t earn you much and to many feels like a wasted opportunity. I would agree, but there is some value in exchanging a potential return for the safety of funds that are immediately available. However, there are alternatives. As interest rates have risen over the years, many banks are paying higher interest rates on deposits, but it is important to read the fine print: Some will require the funds to stay there for a certain period of time in order to earn the rate. Certificates of Deposit (CDs) are also generally a safe place to store cash, but beware of penalties for early withdrawal. You can also consider T-bills, which are any government obligation with a maturity of less than one year. As with anything else, there is a catch. The value of T-bills will fluctuate with changes in interest rates. If interest rates rise, they can fall in price, affecting what may be available if the funds are needed prior to maturity. Finally, you can buy a money market mutual fund that will generally carry a higher interest rate and can be available within two days, which is how long it takes a mutual fund to settle when sold.
The meat and potatoes of any good portfolio is a well-diversified exposure to stocks and bonds, whether selected individually or in a mutual fund or an Exchange Traded Fund (ETF). However, their liquidity is often misunderstood, because they (especially stocks) are always referred to as long-term investments. However, that categorization has more to do with volatility and less to do with liquidity. It is generally not a good idea to invest in stocks or longer-maturity bonds when the funds will be needed in a short window, that is, less than two to three years. As we’ve all seen, stocks can go through downturns, sometimes sustained ones, and ideally you wouldn’t want to sell one of them to raise funds for an emergency. That aside, they can still be a source of liquidity as they can be converted to cash quite easily. As noted above, mutual funds and ETFs can be sold quickly on any given day, with the funds available two days later. One caveat, particularly when it comes to individual stocks (as well as some mutual funds and ETFs): Things can go wrong, and it may not be easy to find a buyer for your individual position. It’s important to know what you own.
In the above section, we are referring to investments available in the public markets, that is ones that trade on an exchange or over the counter. For more qualified investors, there is also private equity. Here professional portfolio managers find opportunities with companies that are not publicly traded and place investor dollars with them. The intent is to oversee the company, improve operational efficiency and thereby increase shareholder value. While these investments do tend to make distributions, you shouldn’t expect the full value of the investment to be returned before 5 to 10 years. The idea is to get returns not available in the public markets, but at the expense of near-term availability of funds.
During times of hardship or emergency, many turn to the balances available through their employer’s retirement plan, including 401k and 403b plans. While that is an option, we generally recommend it as a last resort for a couple of reasons. First and foremost, these plans often are an investor’s biggest source of retirement savings and any withdrawals hurt the ability to reach that goal. Secondly, if you are borrowing from the plan with the intent of paying it back, it hurts in two ways – the funds are no longer in investments growing, and future contributions do not go back into investments until the balance of the loan is fully paid. Also note that, other than for one-time hardship, any withdrawals prior to age 59 ½ are both taxable and penalized at a rate of 10%. It is important to know all the plan rules prior to considering accessing what is in your plan.
Here it is important to know the rules as well. IRAs are significantly less liquid than a taxable brokerage account, simply because of the tax laws. Similar to employer plans, anything withdrawn from a Traditional IRA prior to age 59 ½ will be taxed and penalized. Once a year, you can access funds in an IRA, but they must be paid back within 60 days or the aforementioned taxes and penalty will apply. Roth IRAs have similar restrictions on earnings, but contributions can be withdrawn anytime without tax or penalty. When it comes to the accumulated earnings, though, there are many nuances, so make sure to do some reading or consult a professional before accessing these accounts.
As noted earlier, and as we have seen in the Trump fraud appeal, real estate is a complex source of liquidity. There are a few considerations:
- Selling a home can take time. That sounds anachronistic given the real estate environment post-Covid. But ignore the time it takes to get an offer and consider the time it takes to complete a transaction. Getting everything in order, including an appraisal and title searches, can take at least a month.
- Borrowing against a home (as in a home equity loan or line of credit) can also take time. Banks will likely require an appraisal and run credit checks, which can be quite detailed. Furthermore, with interest rates rising over the last few years, the days of cheap money to “take out of” your home are behind us.
- Accessing liquidity from a commercial property can be challenging as well. The market for commercial real estate is not what it once was, and the specific attributes of the property have become even more important. One option that may be available is a sale and leaseback where the building is sold to another owner, but the space is kept by making lease payments to the new owner. Again, that requires finding a buyer for a property that may and may not be in demand.
Liquidity is an important part of your financial picture and, as this article illustrates, it is not quite as simple as it may seem. Aside from straight cash held at a bank, there are all kinds of rules and catches. While the bank may not pay much, the funds are always there at the ready and sometimes that is worth the return sacrifice.
Chartered Financial Analyst Timothy Baker is the principal owner of Metric Financial, a Simsbury, Connecticut-based investment management and financial planning firm that offers educational sessions and public seminars on creating and preserving wealth for retirement. For more, visit metricfin.com.
