Portfolio Liquidity: A Fluid Situation
David Furst, CFA®, Advice Strategy
Taylor McLeod, Analyst
Picture this: You are in line to check-out at the grocery store, and the person in front of you stands at the register and is presented with their bill; but instead of reaching for a wallet in search of cash or a credit card, they dial their cell phone. They call their financial advisor and instruct her to sell a few shares of stock, then transfer the proceeds to the grocery store’s account.
Although this scene is extremely unlikely, it illustrates a common issue that investors face on a daily basis: how to manage their financial liquidity. Liquidity simply refers to the ease in which an asset can be converted into cash. This not only takes into account the amount of time the conversion takes, but at what price. If an investor must wait weeks to find a buyer for the asset they are trying to sell, or if the investor must heavily discount the asking price in order to sell more quickly, that asset is not very liquid.
The graphic below depicts the relative liquidity of a few financial instruments. Perhaps if the grocery store shopper considered the liquidity of their assets more thoroughly, they would have been able to check-out much faster.
Determinants of Liquidity
As the previous chart suggests, some types of assets are inherently more liquid than others. At the top of the scale is cash, as it takes very little time or effort in order to access. In all likelihood, the majority of investors’ portfolios consist of assets falling somewhere in the middle of the liquidity range (publically traded stocks, bonds, mutual funds, etc.). On the other end of the spectrum are assets that may require additional time, or effort to convert to cash.
Jewelry, coins, bullion, etc. that may require a particular dealer or buyer that specializes in such items.
Primary home, investment property, etc. whose transactions typically involve an agent, plus weeks, months, or even longer to complete a sale.
Art, wine, vehicles, etc. that may involve an auction, selling fees, and specialized buyers in order to sell.
However, the characteristics of the assets themselves are not the only determinants of liquidity. The location of these assets also plays a role. Both in reference to account type, in the case of financial assets, but also geographic location, in the case of physical or real assets.
First, consider a financial asset such as a share of stock. The ultimate liquidity of that share is not just determined by the volume of trades those shares experience on any given day on an exchange, but also the type of account in which it is housed by the investor. Some accounts carry restrictions that impose penalties for early withdrawals (such as the case for tax-advantaged retirement accounts, 401(k) and IRAs) or penalties for withdrawals not consistent with the account’s purpose (such as 529 plans for education expenses, or Health Savings Accounts for healthcare costs). Assets stored in these accounts could be considered less-liquid than the same asset stored in an account without such restrictions.
In the case of physical assets, even when considering cash itself (the most liquid of all assets), dollar bills stored in a piggy-bank at home are less liquid than a buck stored in the pocket of your jeans.
Liquidity in a Planning Context
Liquidity becomes even more critical to consider in the context of an investor’s financial goals. For most, goals can be described most simply as certain amounts of money needed at particular points in time. However, when the time comes, investors will likely need to fund their goals in the form of cash, rather than in the form of financial securities or art. Of course, exceptions exist for example, a charitable donation of stock or repurposing a piece of real estate investment property to serve as a retirement home.
Your financial advisor has the tools and resources to incorporate your financial goals into your long-term plan. To illustrate this, consider a goal of funding a child’s university education. For most, this involves multiple payments of cash over the course of a few years at some point in the future. When the tuition due-date nears, the portfolio of securities would likely need to become less risky, more stable, more liquid, and more accessible in order to ensure the tuition payment clears. The graph below depicts a hypothetical example of how the cash required over the child’s age increases as he approaches his college education years - requiring strategic planning for liquidity needs.
Especially in the case of relatively large financial goals such as funding higher-education, the chances that your goals become a reality can be improved by starting early, having a long-term focus, and putting a plan in place with your financial advisor.
Liquidity in an Everyday Context
In addition to managing the liquidity of an investment portfolio, investors should also consider their levels of liquidity for everyday spending, short-term goals, and emergency savings. In general, experts recommend 3-6 months’ worth of spending needs in the form of cash savings kept in a readily accessible account, such as a checking or savings account. However, everyone’s financial situation is unique, and the exact amount of savings will depend on personal circumstances and preferences.
Whatever the ultimate amount of cash required is, managing this balance of personal liquidity should be done on a regular basis.
To illustrate this process, the chart below depicts the balances of a hypothetical investor, Juana, who’s spending, and circumstances indicate she maintains roughly $50,000 in cash.
After a few months, her car needs a pricey repair, depleting a portion of her cash reserve. Following this unexpected event, she prioritizes savings and is able to build back her cash reserve.
Next, she is planning a remodel for her bathroom which is expected to cost $15,000. Rather than pay the contractors out of her cash reserve, she saves a portion of her income over time. When she has accumulated sufficient funds, she completes the project.
Juana then begins to plan a big vacation. Again, she saves a portion of her income in order to fund the costs. When the trip nears, the airline offers to upgrade her seat to first class at a promotional rate and she partakes. Upon arriving at her hotel, the manager informs her that they have one suite left at a reduced cost, so she upgrades. As a result, Juana greatly enjoys her luxury getaway. However, she overspent her budget for the trip and depleted a portion of her cash reserve. She then reverts back to savings in order to recover the ‘steady-state’ level of cash she needs to maintain over time.
Special Liquidity Situations
Because every investor has a unique financial situation, there is no single solution to the proper management of liquidity. Additionally, investor preferences, tolerance for risk, and financial goals can change over time. As a result, there are often situations that require special attention to liquidity in the context of a portfolio:
One such situation that occurs regularly is an investor who holds a large or concentrated single position in a particular investment or security. The concentration causes more of an elevated level of risk than the investor would normally be comfortable assuming. However, the investor may have an emotional attachment or personal interest in maintaining the position. For example, an accumulated holding in an employer’s stock by a long-time employee or investments that were inherited from a family member.
In this case, the investor is imposing liquidity restrictions on themselves by insisting the position be maintained and not considering diversifying or selling the investments. As a result, the investor’s asset allocation and the expected portfolio performance (from both a risk and return perspective) will likely be impacted.
A Fluid Situation
Liquidity is not a static aspect of financial life, but rather a fluid situation that changes over time and with the fluctuations in the market.
Personal circumstances are often far more complex than the simplified examples provided here. However, with some attention, a long-term plan, and the help of a trusted financial advisor, investors can better manage unexpected curveballs like a pricey car repair, and make strides toward achieving aspirational financial goals such as a new home remodel or funding a child’s education.
RESEARCH, CHARTS, AND ILLUSTRATIONS PROVIDED BY JUANA DIEZ DE ONATE – INVESTMENT IMPLEMENTATION ANALYST
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