Consider the case of the man in Manhattan who hailed a taxi in the pouring rain. Only after they were underway did the man realize he had no cash and the cab driver didn't accept credit cards. But the cabby agreed to stop at a nearby automated teller machine. Unfortunately, the rain had caused a power outage, and the man was unable to make a withdrawal. Four ATMs later, the man was still without cash and his fare had climbed to $20. You could say this man had a liquidity problem.
The man in our story eventually worked something out, but we can see from this example why the element of liquidity is usually the most important to investors. We generally define liquidity as the ability to convert an investment to cash, without risk of loss, whenever we need it. And, usually, that need is sudden, unexpected and unforeseeable—namely, an emergency.
The discerning investor, however, realizes that most emergencies do not require access to all the money he or she has tied up in investments. In the same way, not all liquidity needs are sudden and unexpected. Therefore, an investment's liquidity (or lack thereof) must be measured in the context of the overall purpose of the investment. Not unlike the element of risk, sometimes liquidity must be traded for a potentially higher return on investment.
Savings and Money Market funds obviously receive our highest liquidity rating on the chart to the right. For that reason, most people keep their emergency funds (3 to 6 months of expenses) in these types of investments. This type of investment also lends itself well as a repository for any funds you will need in the short-term (usually, less than one year).
Stocks and Bonds rate slightly lower on the liquidity scale because of the risk of loss of principal if you are unable to plan the timing of a liquidation. Nevertheless, there are ready markets for both these investment types. Further, with bonds, you can improve liquidity by "laddering" their maturities–instead of buying one bond with one maturity date, buy several smaller bonds with staggered, incremental maturities. For stocks, when you hold them in a brokerage account, you can generally borrow against them with a margin loan, enabling you to obtain cash without actually liquidating the investment.
Limited Partnerships, on the other hand, are extremely illiquid investments. Remember, that doesn't make them inappropriate to include in a well-diversified portfolio; it only means that they are not readily convertible to cash. Many long-term investors enjoy the ease of management and potential for appreciation these investments can provide–they just don't invest their emergency funds in them.
At first glance, many people don't think of real estate or their own homes as terribly liquid investments. But, just as stocks can be viewed as more liquid because of margin loans, real estate, too, can be leveraged to provide ready cash. And, as we discussed in the article on Flexibility, there is a market for real estate.
Another way to look at the liquidity rating of some investments is that they are receptacles of liquidity—investments designed to preserve liquidity until it is actually needed. For example, you might purchase an annuity at age 30 with the intention of holding on to it until you retire at 65. In the intervening thirty-five years, the investment preserves your capital, and provides tax-advantaged accumulation of income. As retirement approaches, you can choose whether to liquidate the investment in a timely, orderly fashion, annuitize it and live on the cash flow or preserve it and pass the asset on to your heirs.
Liquidity, like the other eight elements, is a personalized rating, and subject to your specific goals and needs. Depending on your particular requirements for the money you invest, some investments will rate better on the liquidity scale for you than they will for someone else. And remember, while some liquidity in your investment portfolio is important, not all of your assets need to be liquid.
Elements of Investment
Elements
Savings & Money Markets
Stocks
Bonds
Limited Partnerships
Real Estate
Commodoties
Home
Risk
8
6
7
2
5
2
9
Management
8
7
7
9
4
5
7
Flexibility
4
8
7
1
5
2
7
Liquidity
9
8
7
1
6
1
7
Cash Flow
-
-
-
-
-
-
-
Rate of Return
-
-
-
-
-
-
-
Appreciation
-
-
-
-
-
-
-
Leverage
-
-
-
-
-
-
-
Taxes
-
-
-
-
-
-
-
Total
-
-
-
-
-
-
-
|
|
Moorman and Company, an accounting and personal financial management firm based in Palo Alto, serves the San Francisco Bay Area, Peninsula, and Silicon Valley from Hillsborough to Saratoga-Los Gatos, including Atherton, Menlo Park, Los Altos, Los Altos Hills, and Cupertino.