Liquidity is an important term to understand in investing, and in daily life. It describes the ability to exchange an asset for cash. A highly liquid asset is one that can be turned into cash quickly.
The term "liquid asset" is most often used when talking about investments in a stock market. Liquid assets are those that have a ready pool of buyers willing to pay the market price. In contrast, illiquid assets are those with few buyers. With an illiquid asset, the owner may have to wait a while to find a buyer willing to purchase the asset. Many penny stocks, for instance, are illiquid assets because they are not as quickly bought or sold as higher valued stocks.
- Liquidity describes the ability to exchange an asset for cash. Liquid assets can be turned to cash quickly.
- Investors should keep at least some portion of their net worth in liquid assets.
- Even if you don't invest in the market, you still need a cash reserve.
- The level of liquid assets you should keep on hand depends on your monthly budget and other factors.
Why You Should Keep Liquid Assets on Hand
What if there were a tragic or extreme event in your area and you suddenly couldn't report to work? How would you survive if you couldn't access the money you may have locked away in accounts?
If you planned for such an event, you would have liquid assets at the ready. You may be able to stay afloat for months using your cash reserves. You could purchase groceries, bargain with neighbors, or barter for goods using your liquid funds.
In the aftermath of the September 11, 2001, terrorist attacks in New York City, the financial system was shut down for four very long days. When the stock exchanges closed, investors learned how crucial it was to keep some measure of liquidity in their holdings. This is because for four days, many people lost access to cash and investments. There was no guarantee that they would be able to sell their stocks or other securities when they wanted to, or even in the near future. This forced many people to sit on their holdings without knowing what their quoted market value would have been.
Years later the lesson remains true. The major caution to keep from that time is that at least some portion of your net worth should be kept in liquid assets.
Even if you don't invest in the market, you still need a cash reserve. When most of New York City was shut down in the wake of the terrorist attacks, many businesses could not operate. In some extreme cases, employees went without pay for many weeks, leaving them without a source of income.
Your liquid assets have one main job, and that job is to be there when you reach for them. Earning a return comes second to having cash on hand when you need it.
The Great Recession
The U.S. came close to a liquidity crisis in 2008 and 2009 in the midst of the Great Recession. During this period, a crisis caused by speculation in the housing market spread to many large banks, firms, and other financial institutions, shaking them to their core. There were even rumors of brokers calling their spouses and warning them to go to the ATM and pull out as much money as they could get in case the banks weren't open for weeks or months.
Liquid Assets and How to Store Them
Recall, highly liquid assets are those that you can turn into cash quickly. When used as a metric—or in other words, when stating how liquid something is—liquidity falls on a broad spectrum of many types of assets. On one end of the scale are the dollar bills and coins you have stuffed in a cookie jar or mattress at home. Indeed, cash is the most liquid asset of all, meaning you can spend it at a moment's notice, and without having to first convert it to any other form. However, it is also the least safe, because it can be destroyed by fire, lost, or stolen. On the other end of the scale are assets such as real estate, which can take months or even years to convert into cash.
When it comes to storing liquid assets, here are a few of the most common places people choose to keep their cash:
- Their house (in a place that is well hidden and safe)
- A savings or checking account at their local bank or credit union
- A money market account
- Short-term certificates of deposit
- Short-term U.S. Treasury bills
For the most part, keeping your money in a bank or credit union is very safe. The country's banks have not been frozen since 1933 when Roosevelt declared a "banking holiday." This lasted a week and led to our modern banking system, and the FDIC.
You should not think of stocks, bonds, mutual funds, annuities, or insurance policies as liquid enough to be used in an emergency. Not only are they subject to normal shifts in the market, but they can also become illiquid if the market closes.
Money market funds are accounts that can be opened at banks or credit unions to earn extra interest. They are very safe, but there can be issues with liquidity in the event yours is run by a mutual fund company. You may lose access to your cash if the financial markets shut down, which is precisely what happened to many investors on September 11.
How Much Liquidity Should You Have?
The level of liquid assets you should keep on hand depends largely upon your monthly expenses. You should have a budget (or a solid idea) of how much you spend each month on housing, food, transport, etc. There are also a number of personal factors that weigh in, such as the city you live in, and how many people might rely on you for financial support. If you don't know how much money you need to survive on a monthly basis, a financial planner or advisor can help you figure out what a proper fund might look like for you. In all cases, you should be able to support yourself and family for at least a few months.
Liquidity is a safety net for you and your family. Most financial planners agree that six months is an ideal amount to keep in an emergency fund.
You probably don't want to put several thousand dollars under your mattress, but putting it into a local bank or credit union is wise. If you do most of your banking with an account held at a remote or online provider, you may have problems reaching the cash if major systems should shut down.
Keeping several months' worth of liquidity will ensure that you are prepared, whether it's for something as major as a global emergency, or for a more common issue such as car repair, job loss, a trip to the emergency room, or more. A liquid fund will also keep you from having to take on extra debt when these things occur. In sum, having cash on hand can help you to stay afloat in times of crisis, and it can give you peace of mind in other times.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.