You may not have chosen your investments based on what investments are “liquid” or “non-liquid,” but understanding the difference is important to your overall financial planning.
Liquid Assets
“Liquid assets” are defined as holdings that can quickly and easily be converted to cash.
It’s easy to identify some assets as “liquid.” Cash, for example, can immediately be accessed and used.
Other assets are more on a continuum. They may be “liquid,” but there’s a possibility that selling them may result in a loss.
Stocks are at the other end of the spectrum of liquid assets. If they are listed on a major stock exchange, they can be instantly sold, but the value you receive for them will depend on many factors at the time.
In the middle of the spectrum of liquid assets are Treasury bills and bonds, corporate bonds, mutual funds, money market funds, and commodities. As with stocks, you can convert these assets to cash quickly, but the price you receive can fluctuate.
Illiquid Assets or Non-Liquid Assets
In contrast with the ease of selling liquid assets, illiquid assets can’t quickly be converted to cash. Examples of illiquid assets are real estate, collectibles, stock options, private equity, and intangible assets like intellectual property.
Real estate is a good example of an illiquid asset. It’s not impossible to sell it quickly if you are willing to do so below market value, but it often takes an extended period of time to dispose of it. As an alternative to selling real estate, you may be able to borrow against the equity you have built up, but making those arrangements can also be time-consuming.
Liquid vs. Non-Liquid Assets: A Delicate Balance
We’ve all heard the term “cash poor.” It often refers to people who may have a significant net worth if you consider their illiquid assets but have cash flow issues because they don’t have enough cash to fund current expenses or deal with financial emergencies.
Owners of businesses often fall into this category. A significant portion of their capital is invested in the business, leaving them with few liquid assets.
Balancing your holdings between liquid and illiquid assets can be a delicate undertaking. You want to have enough cash to meet your needs and deal with unexpected expenses, but holding too much cash has a downside.
As a general rule, the more liquid the asset, the less it’s likely to increase in value over time.
Cash is a good example. Unless the return on cash keeps pace with inflation, the loss of purchasing power will erode the value of your cash holdings, especially over time.
That’s why many experts advise holding only three to six months’ worth of living expenses in cash. If you are concerned about unexpected events like job loss, consider keeping as much as one year of expenses.
The Role of Investments
Young investors should have a significant amount invested in assets that are likely to increase in value, especially over the long term. These investors can tolerate more risk because they have the benefit of time, which permits them to earn returns from years of compounding.
However, due to a lack of financial education or other factors, this is not happening. According to a survey from Personal Capital, investors in their 20s have 28% of their wealth in cash, a similar percentage as investors in their 80s and 90s who don’t have the benefit of time to see their assets grow.
There are exceptions to the rule about only holding cash you need for expenses for a stated period or financial emergencies. For example, if you need access to your assets to buy a house, purchase an interest in a business, or for similar expenses within 18 months to three years, you should keep those assets liquid and not subject them to stock market risk.
While historical precedent isn’t predictive, it’s useful to understand that it can take a significant time for stocks to recover from a major decline. You don’t want to be in a position where you have to sell stocks at a loss to fund a planned expense.
Allocating between liquid and illiquid assets can be complex, requiring multi-factor analysis and probably the help of a financial advisor.
But once you decide to invest in less liquid assets like stocks, analyze your tolerance and ability to take the risk, the role of fees and expenses, and the benefits of global diversification, among other factors.
Learn more about investing, and schedule an appointment with Allied Integrated Wealth.
