Liquidity: The Oxygen equivalent of money

Investing is like running a marathon. Long run, really really long run. But money is not a sport where you know with absolute surety about requirement being some distance away. Sometimes need of money can be predicted well in advance but many a times, sudden need for cash may arise due to unforeseen circumstances. Life events like Job loss, medical emergency, natural disaster or law enforcement issues may mean cash is required right than. Effects of most of these emergencies can be mitigated using insurance but insurance claim is a fairly long process which most times is based on reimbursement and hence you have to pay cash from your pocket (mostly savings) first. It may not be very easy to convert savings stashed in PPF, NPS or real estate etc to cash. This ability of an saving to be able to converted in cash on demand is called as Liquidity.

Liquidity is mostly a neglected aspect of savings. People talk about expected returns and risk, sometime tax implications as well but mostly ignore liquidity. But liquidity becomes most crucial aspect in emergency circumstances. Imagine all your wealth being locked out in real estate and when you need money. You can not sell property in a day or two, hence you will need to take loan. Which will be very expensive. Personal loans cost more than 14% per annum and in case of no regular stream of income even they may not be available. You will have to sell property in distress and may not be able to realise its full value. Sometimes distress sale results in lower valuation of up to 70-80%. That is equivalent to losing that much wealth only because of liquidity. So it just sums up why ensuring some of the investment in liquid instruments is necessary.

Traditionally investments are classified as 2 types as far as liquidity is concerned

Liquid investments:

These are all the stuff which can be converted in cash at very short notice. Best of all is savings bank account. Other instrument includes Gold, Bonds and debt and equity funds which do not have any lock in period and equities which are traded well on stock market. Most of these things can be converted in hard cash at a very short notice. But we divide this kind of instruments in 2 parts

1. Instruments with low risk: It will involve liquid investments which also have low risk. It means you can convert investment in cash on a value which is largely in line with your expectations. For example in short term sovereign bonds or sweep in FD’s, there is virtually no possibility of capital loss even if you have to take money out at a very short notice
2. Instruments with high risk: These instruments are liquid but comes with moderate to high risk. Long term sovereign bonds, corporate bonds, mutual funds and equities comes under this category. One should consider these instruments as fairly illiquid due to risk manifested in them. It may be possible that when you need money, equity market are in a stress and you have to sell your investments at a discount as much as 30-40%. While some high risk investments are theoretically liquid, due to murphy’s law they tend to cash out during time of distress in the market and hence at a considerable loss.

Illiquid Investments:

As name says these are the instruments which can not be converted to cash easily. These are both paperless Investments with lock in period like PPF, Fixed FD’s NPS, ELSS etc and physical assets like Real Estate and vintage things like paintings, old wine (Yes these are investments), collectible items etc. It is very difficult (virtually impossible) to dispose of these investments in short duration of time.

Financial world is too complicated to such simple classification, so there are other products which are supposedly illiquid but provides some flexibility like FD’s with overdraft facility. This is basically an arrangement of FD with a facility to draw a loan on it with some additional cost. So if Interest rate on FD is 9% bank agrees to give a loan of upto 70-80% of that amount for 10.5-11% interest rate. You can repay that loan according to your convenience. Similarly PPF allows you to withdraw your corpus in some special circumstances like medical emergency, to buy a home etc. Some other instruments have tax implications if premature.

Another important aspect related to liquidity while investment planning is liquidity is not a key consideration after a certain amount of money is in liquid instruments. As a thumb rule most of the advisors advise it to be 6 months of monthly expenses but I do not believe in thumb rules in investing. They are just good benchmarks which anyone can use to make intelligent decisions.

In end liquidity is an important consideration while investing and that is why liquid investment come at a premium to investor or stating it other way round illiquid investments generate better returns over a long period of time.

Another important factor while making investment decisions is risk, read about it here. Let us know what do you feel about liquidity in comments.

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