How much cash do you need to keep in reserve for emergencies while also investing for long-term goals like retirement? Your liquidity needs relate to how much money you need access to quickly. The higher your debt or other risk needs, the higher your liquidity needs.
Smart investors will want to keep enough cash reserves to meet short-term needs while investing for the future. Find out how to get the right balance of liquidity needs for your goals here.
Introduction to financial liquidity
Financial liquidity is a measure of an asset’s ability to be quickly converted into cash without a significant decrease in its value. For an asset to have high liquidity, there must be buyers and a market to sell it. An asset is considered illiquid if you are forced to sell the asset for a lower value or incur significant fees.
For example, if you have a rare family heirloom appraised at $100,000 and you have no buyers, that is a highly illiquid asset. But stocks from Amazon.com Inc. (NASDAQ: AMZN) or Intel Corp. (NASDAQ: INTC), which trade millions of shares daily, are highly liquid assets.
Liquidity can be measured in terms of market liquidity and accounting liquidity. Market liquidity, as the name implies, measures how much movement there is in the asset’s market. A greater number of daily or weekly transactions for a specific asset indicates higher market liquidity.
Accounting liquidity refers to how easily an individual or organization can meet financial obligations with their liquid assets. Accounting liquidity is the ability to pay off debts as they become due.
Both types of liquidity can affect you. In the example above, the rare heirloom would not have market liquidity, which could affect your accounting liquidity if you need that cash to pay other debts.
What are my liquidity needs?
Liquidity is measured through different types of systems that have formulas to measure a company’s ability to meet its short-term obligations. The simplest measurement of liquidity is the ratio of current assets that can be converted to cash within one year against current liabilities. The higher the ratio, the greater the liquidity.
Current Ratio = Current Assets / Current Liabilities
If you have assets worth $50,000 and liabilities in the form of student loans and credit card debt worth $25,000, your current ratio is 2. Any ratio above 1 is considered good liquidity.
In order to determine your liquidity needs, consider how important the benefits of financial liquidity are and how important each factor below is to you. You’ll want to weigh access to funds, debt, risk, and credit available to decide your financial liquidity needs.
1. Access to funds
Having cash available means that funds are available for short-term needs and investments. You’ll also want to maintain some cash reserves in case of emergency. Financial experts offer varying opinions on how much cash to keep in reserve, but many suggest three to six months’ salary.
You can keep these funds in a high-yield savings account to maximize earnings and reduce the lost value from inflation. You may also choose to keep more cash on reserve if you’re saving for a short-term goal like a mortgage down payment or a vacation.
2. Reduced debt
Having cash available allows you to pay off debt when necessary, avoiding high-interest payments and keeping your balance sheets healthy. This can also help you avoid additional debt, as you will have cash available to cover expenses. If you don’t have any debt, you may need less cash in reserve.
Individuals will want to have enough cash in reserve to cover mortgage or rent payments, utilities, and other regular monthly expenses. Covering debt is especially important for small businesses where delayed customer payments can cause liquidity issues. Whether you’re an individual or a business, be sure to keep enough cash in reserves to cover upcoming debts for a minimum of the next one to three months.
3. Risk Management
Having cash available can help you manage the balance sheet by providing a cushion against unexpected losses. Whether that’s a client that falls through or a car that breaks down, it’s better to be prepared for unexpected expenses and losses. If you don’t have enough cash reserves or highly liquid assets, you’ll be forced to sell other assets for less than their market value to meet cash needs.
4. Increased Investment Opportunities
Having cash available allows you to take advantage of investment opportunities when they arise. If you have low liquidity, you may not be able to take advantage of short-term opportunities. But sitting on a large amount of cash reserves means you’re missing the growth opportunities in a mutual fund or other relatively liquid assets where your money could be earning more for you.
5. Increased Credit Availability
With some lenders, having more liquidity may enable you to secure better loan terms. Demonstrating cash reserves or savings may be seen as a guarantee against the loan, allowing you to more easily get a higher loan value or lower interest rates.
How to invest if you have high liquidity needs
Do you have a shorter-term goal? For example, are you in the process of paying off your student loans or saving for a house in the next couple of years? If so, your liquidity needs may be high, which requires having cash on hand to pay these expenses.
If you have high liquidity needs, saving and investing using highly liquid investments is the best strategy. It also may make sense to invest more conservatively, which could help avoid a situation where a drop in the market causes you to not have enough cash or, possibly worse, to have to sell investments when the market is down.
While your liquidity needs are high it might make sense to only invest — usually using dollar-cost averaging — whatever funds are intended for long-term goals like retirement.
Consider the highly liquid investment types below
Cash
You can save cash in saving accounts, certificates of deposit (CDs), or money market accounts. Money market accounts are interest-bearing savings products you can get at banks and credit unions. You can usually get a debit card and checks linked to the account, although there is a limit on the number of transfers or debits per month.
A CD is an account used to save money for a set period of time with a specific interest rate. The time period on a CD ranges from a few months to five years or more. Once a CD is opened, you cannot withdraw the funds until the time period has passed, or you’ll have to pay a significant penalty.
In addition to a standard savings account, consider a high-yield savings account that offers higher interest rates and bonuses for large deposits. Savings accounts are similar to money market accounts, except that you won’t get a debit card or checks with the account.
Stocks
Stocks are a form of security in which the holder has proportionate ownership in the issuing corporation. Stocks are sold predominantly on stock exchanges. Stocks are generally highly liquid investments. What does liquidity mean in stocks? The greater the daily trade volume, the more liquid a stock is. A stock with 70 million daily trades has greater liquidity than a stock with only 100,000 daily trades, but most stocks on major exchanges are considered highly liquid investments.
Bonds
A bond is a fixed-interest loan instrument. Usually, a bond is held by an investor with a company or the government. Bonds with low transaction costs are considered highly liquid investments while other bonds may have lower liquidity. You can sell bonds listed on major exchanges quickly for cash via a broker, making them highly liquid.
Exchange-traded funds (ETFs)
Exchange-traded funds are a type of pooled-asset security that includes many individual stocks and bonds. ETFs are traded on major exchanges and are usually considered highly liquid investments.
How to invest if you have low liquidity needs
If you are focused on retirement many decades away, or if you don’t have any near-term large purchases planned, you may have lower liquidity needs and can afford to invest in more illiquid assets. This will help you diversify your portfolio and possibly protect against the performance of the markets in times of economic downturn.
Retirement accounts
Retirement accounts are set up as early as possible with a focus on building long-term wealth for retirement. Retirement accounts like individual retirement accounts (IRAs) and 401(k)s will have fees or penalties for early withdrawal before the age of 60. You could face both taxes and up to 10% early withdrawal penalties, making them illiquid before 60.
Real estate
Real estate is considered a relatively illiquid asset. Depending on the local market, it could be several months or more to get the full asset value. In some markets or with especially valuable properties, getting the full appraised value could take a year or more.
In many long-term wealth-building strategies, real estate is a wise investment because the long-term value often outpaces market performance. The value increases if the real estate property is income-generating in the short term through rental income.
Hedge funds
Hedge funds are pooled investment accounts that trade in more liquid assets like stocks and bonds. With a hedge fund, you’re often restricted in how often you can withdraw funds, making them an illiquid investment that can lead to long-term investment returns.
Finance Liquidity Final Tips
How do you know whether you’re meeting your liquidity needs? If you have enough in savings accounts, CDs, or money market accounts to meet three to six months of expenses, then you’re probably meeting your liquidity needs. Investing a portion — up to one year’s expense — in liquid assets like stocks, bonds, and ETFs will ensure strong liquidity while protecting your long-term investments.
As you build liquidity needs, don’t forget to focus on long-term investing goals through retirement accounts, real estate, and even hedge funds.
FAQ
What does liquidity needs mean?
Liquidity needs mean the value of assets you need to be able to easily access or convert to cash without significant loss of value.
Is a 401(k) a liquid asset?
A 401(k) is not generally considered a liquid asset because it’s intended for retirement. A 401(k) account may also be subject to restrictions and penalties for early withdrawal, further reducing liquidity.
What is investment liquidity?
Investment liquidity is how easily a stock, bond, or security can be bought or sold in a secondary market. A liquid investment is one that can be sold easily, without paying fees, to get the full cash value of the investment.
