The Recipe for Liquidity
When you hear the word liquidity, your thoughts probably go to water, or wine, or something similar. And up until the late 1800s, that is exactly what this word was associated with, the quality of being liquid. In 1897 however, the term began being used in finance and not because people were using liquid money. After an extensive search into why this word started being used in finance, I have come up empty handed. If you have any insights into this, please enlighten me in the comments below.
Anyway, now that you know that we won’t be discussing mixology or any other liquids, you’re probably asking, “WTF does liquidity mean?” Liquidity is how quickly you can turn an asset into cash at its current market value aka full price. Anything that is bought and sold has a level of liquidity. Cash is the most liquid asset because, well, it’s already cash! Other assets, including investments and physical assets, have varying degrees of liquidity. Below we will discuss some of the different asset types and why their liquidity levels differ.
Last week we discussed the varying risk levels associated with different investment types, and how to structure your portfolio to reduce risk. (see that post here.) While investments vary in riskiness, they also vary in liquidity. Some investments such as certificates of deposit (CDs) have fixed investment periods. These are basically loans you’re giving to the issuing entity. They work like this. You buy a 10-year CD for $1,000. The issuer pays you a defined amount of interest for 10 years, and at the end of the 10 years they pay you back your $1,000 principal payment. Since the investment period is defined and you won’t receive your principal back for 10 years, this asset is considered illiquid. If you must sell early, you will incur a penalty, which means that you will sell the CD at below market value. Since the definition of liquidity is how quickly you can turn an asset into cash at its current market value, this loss in market value for selling early is another example of why CDs are considered illiquid.
Like CDs, stocks and bonds are two other investment types, but they offer much more liquidity. Stock and bond markets are always open for trading. This means that you can easily buy and sell them at their current market value whenever you want. However, always having the ability to sell does not mean that you will always sell at a profit. If you bought a stock for $10 and in 3 years you needed money and decided to sell your stock, you would be able to sell it (pro), but if the stock price had declined to $8, you would sell at a loss (con). Being able to easily convert an asset to cash doesn’t mean that you will always make money on that asset, but it does mean that if you are in a bind and you need money now, you can get it by selling your asset at full price.
How about investment accounts like 401Ks and IRAs? 401Ks are not liquid. Once the money is in your 401K, you will not be able to take the money out without incurring a penalty until your sixties. Again, part of liquidity is receiving the full market value for your asset, and the penalty you incur from an early withdrawal means that you are not receiving the full market value.
Roth IRAs are a much more liquid retirement account. The money you contribute to your Roth is after tax, meaning that you already paid income tax on it, so you are able to withdraw any contributions you’ve made to your Roth at any time. This does not apply to any earnings you’ve made. You’ll still have to wait for those. But it does give you a penalty free withdrawal option on your contributions. This means that if you contribute $1,000 to your Roth, earn $50 on your investments in your Roth, and then need to withdraw money, you can withdraw up to $1,000 without any penalties. Not bad! And why Roth IRAs are a great liquid investment option.
Some other personal assets you may own are a car and a house. These are physical assets. Unlike stocks and bonds, physical assets tend to be less liquid. You may have heard of people “pricing their house to sell”. Obviously everyone prices their house to sell, but this phrase means that they listed it at below market value because they want to sell it quickly. To reiterate again, selling at below market value to get money fast means that the asset is not liquid. Why, my friends?! Say it with me now! Because for an asset to be liquid, you must be able to easily convert the asset to cash at the FULL MARKET VALUE. You all are liquidity pros! Go reward yourself with some actual liquidity, a drink!
JK we’re not done yet. It is hard to find a buyer for your house because it is unique due to the area it’s located in, the number of bedrooms and bathrooms it has, its style, how well maintained it is, etc. When you narrow down everyone looking to buy a house to those looking to buy a house with your house’s specific criteria, the number of potential buyers gets pretty small. If someone wants to buy stock in Apple, all of the shares being bought and sold on the market are the same, so buyers and sellers can easily trade whenever they want. This sameness is what makes stocks liquid. The uniqueness of physical assets is what makes them less liquid.
So far, we’ve discussed liquidity in terms of personal finance, but liquidity also applies to companies. The liquidity of a company is determined by the amount of cash they have on hand and the amount of liquid assets they have. Just like its important for you to have a savings account in case you lose your job or experience a hardship, the same is true for companies. You want a company to also be able to pay its bills in the event of a hardship. Let’s take a look at the varying degrees of liquidity for a company’s physical assets.
A company will have many physical assets. This will include their building if they own it, all of their machinery, inventory, cubicles, computers, artwork, literally anything they own that you can physically touch. General office items such as cubicles, computers, desks, copiers, etc. will be easier to sell, or liquidate, than more industry specific equipment. The more specialized a piece of equipment is, the smaller the market is for people looking to buy it. Therefore, the more specialized a piece of equipment is, the less liquid it is. Sound familiar?
The same is true of a company’s inventory. The more specialized their product, the less liquid their inventory is. If a company makes luxury yachts, they won’t be able to sell their inventory quickly because the market for luxury yachts is small. On the other hand, a company that makes little black dresses has a liquid inventory because everyone needs at least one LBD!
When determining the financial well being of your personal finances, or a company’s finances, liquidity is a key component. Making sure you have enough money in your savings, along with other available funds to pull from, like your Roth IRA, is important to make sure you have enough liquidity to stay afloat during any unforeseen challenges. It is also a key factor you should use when evaluating your investment strategy, alongside risk. Keep your stress low by managing your risk level, and your health in tiptop shape by managing your liquidity. And, of course, indulging in your liquidity of choice. I’m off to indulge in mine. Wine!
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[…] 10%, and will significantly eat into your earnings. Since these accounts are not very liquid (see this previous post on liquidity), you should always make sure to have other easily accessible money saved to help cover any […]
[…] in index funds first started in 1973, but many of these funds required high minimum balances, were illiquid, and transaction fees actually existed and ate into your earnings. While ETFs have become […]