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What is liquidity and why does it matter?

Updated on: Jan 13th, 2022


7 min read

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The term liquidity in finance refers to the time and the cost it takes to convert an investment into cash. Many times investor focus only on the long-term objective of securing their retirement, not taking into account the possibilities of the unprecedented events. It is essential to give some consideration to liquidity and not have all your capital tied up as you may encounter the need for urgent cash anytime.

Understanding liquidity from a financial perspective

In simple terms, liquidity is the accessibility to your investment. This takes into account how much time it would take for you to access your investment when you are in need. The process of such a conversion differs from asset to asset. In the case of your retirement fund, you will not be able to liquidate the funds without the necessary paperwork that may be time-consuming.

On the other hand, a fund in the money market is very liquid and can be accessed through a linked chequebook or can be easily transferred to your designated bank account. Thus, liquidity is the degree to which a security can be, easily and quickly, bought or sold without having its price affected. Your liquidity is determined by how fast your investment can be converted into cash.

You may have money invested in stocks, and you are suddenly in need of cash. You have the option of selling your stocks quickly for a fee, through a broker, and get liquid cash. On the same light, if you consider a less liquid investment like that of real estate, it is not so easy to convert the sale. This is accompanied by the legal paperwork, the market valuation of the property, seeking out potential buyers, and so on.

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Liquidity – An important part of financial planning

When planning your investments, it is imperative to factor liquidity in your plans to ensure that you have secured both long-term and short-term needs. This will ensure that you are not going to touch your long-term investments.

Provision for cash reserves

Regardless of how much you invest in illiquid assets, you need to have a small portion of your money kept aside to access instantly. This helps to keep the value of your funds intact rather than shifting the value due to any conversions. The cash you have must be used in times of emergencies only, and it must be restocked right away. There is often a debate about how much is the right amount for such provisions, but it is a personal parameter that differs across individuals based on their needs. A rough estimate would suggest having at least three months worth of your take-home salary in cash or near cash reserve.

A balance of liquid and illiquid assets

It is advised to have at least 60% of your invested assets in liquid assets such as stocks, bonds, mutual funds and other alternative investment funds. These are funds that you can encash monthly. In case of a publicly-traded investment option, you will have to ensure to invest with a long-term horizon to avoid any impact on the price. Another vital point to keep in mind pertains to private investments, where a certain fraction of the investment is under options of easy redemption.

Role of liquidity in Investments

Liquidity plays a crucial role in balancing your portfolio with tradeoffs between risk and return. If you invest in emergency funds, you will have high liquidity, but the returns would be low, as will be the risk. Real estate investment comes with low risk and a higher return, but the liquidity aspect is compromised. Opting for stocks and equity mutual fund, in the long run, garners higher returns with liquidity, but this is accompanied by higher risks as well. But despite these scenarios, it is a significant component in portfolio investment.

Liquidity helps accelerate transactions

Having liquid funds significantly reduces the time-lapse from the moment you put the asset for sale to the time you find a buyer. Stocks are a good example of liquid assets which can be traded on the stock exchange on any working day.

Liquidity eases the selling process

It is easier to find a buyer for a liquid asset than for an illiquid one. This does not mean that one must not have illiquid funds at all, but rather, one must not depend on illiquid funds for emergency situations.

Liquidity is a greatly overlooked attribute

The value of liquidity in the investment realm is grossly underrated. In the race to secure the future, many investors miss out on making provisions for the unforeseen events that can come uninvited anytime. Not having this security can force you to dig into your long-term investment plans, defeating their very purpose.

Liquid assets maintain their value

To a huge extend, liquid funds manage to retain their value when they exchange hands, unlike many illiquid funds. When you break into your long-term investments to meet your emergency needs, chances are you’ll undergo a fine. When you sell your real estate or property, you may or may not get the price depending on the market conditions. But when you break you access your savings account, there is no such loss of value of your funds.

When you are investing in various asset classes, ensure you are equipped with ample liquid funds to avail in times of need. To know more about investment options with liquidity, visit ClearTax where we have an assortment of funds that you can choose from.

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