The Importance of Liquidity and Liquid Assets
Liquidity describes the ability to exchange an asset for cash. Known as a liquid asset, these possessions can be turned into cash quickly. The term "liquid asset" is most often associated with investments in a stock market. Liquid assets are those where there is a ready and waiting pool of buyers willing to pay the market price. In contrast, illiquid assets are those where there are few buyers. With an illiquid asset, the owner may have to wait to find someone willing to purchase the property. Some penny stocks are an example of an illiquid asset.
September 11 as an Example
In the aftermath of September 11, 2001, terrorist attacks in New York City, the American financial system was shut down for four incredibly long days. With stock exchanges closed, investors learned the importance of liquidity after they temporarily lost access to cash and investments. They were not guaranteed the ability to sell their stocks or other securities whenever they wanted and could be forced to sit on them indefinitely without knowing what their quoted market value would have been.
Years later, the lesson remains timeless. Namely, investors should remember one important lesson: at least some portion of your net worth should be kept in liquid assets. That liquid portion has one primary job, and that job is to be there when you reach for it. Earning a return is only a secondary, less important factor.
Liquid Assets and How to Store Them
The term liquidity refers to how fast something can be turned into cold, hard cash; the kind you stick in your wallet or cash exchange for something else. Liquid assets are those that are thought to be turned into cash or purchasing power immediately.
On one end of the scale of all assets are the dollar bills and coins you have stuffed in a cookie jar or mattress at home. These are the most liquid assets, meaning you can immediately spend them. However, they are the least safe because they can be destroyed by fire, misplaced, 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 your liquid assets, here are a few of the most common places people choose to keep their cash:
- Their house (hopefully 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
- United States Treasury bills of very short duration
In most cases, depositing your money in a bank is considered extremely safe. America's banks have not been frozen since 1933 when Roosevelt declared a "banking holiday," which lasted three days. An event of this nature seems relatively unlikely to happen again, but you never know.
Money market funds—those in an interest-bearing account at a financial institution—can cause problems because in the event yours is administered 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.
As well, for emergency purposes, you should not consider stocks, bonds, mutual funds, annuities, or insurance policies as liquid assets. In addition to normal market fluctuations, these investments may become completely illiquid if the exchanges are closed, meaning good luck getting your hands on them.
Why You Should Keep Liquid Assets on Hand
Even if you don't own any investments, you still need a cash reserve. Once Manhattan was shut down following the terrorist attacks, many businesses could not operate. In some cases, employees were not paid for several weeks, leaving them without a source of income.
The United States 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 several large financial institutions, shaking them to their core. Some professional investors were rumored to be 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.
What if there was a tragedy or extraordinary event in your area and you suddenly couldn't report to work? Taking the scenario one step further, what if such an event caused your company to run into tough financial times and it either closed its doors or started laying off most of the workforce? How would you survive?
If you had realized the importance of liquidity, you would be able to stay afloat for at least several months using your cash reserves. You could have purchased groceries, negotiated with neighbors, or bartered for goods using your emergency liquidity. Liquidity matters. Liquidity is important. It is a safety net for you and your family.
The Degree of Liquidity You Should Consider Maintaining
The level of liquid assets you should keep on hand largely depends upon your estimated monthly expenses and other personal factors you should discuss with your financial planner or investment advisor. In all cases, you should be able to support yourself and family for at least a month or two. Most financial planners agree that six months is an ideal amount to keep in an emergency fund.
Now, 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 most of your banking is done with an account held at a remote or online provider, you may have problems reaching the cash if major systems should shut down.
It's important to remember that national emergencies are much less likely to happen than personal emergencies such as car repairs, layoffs, washer and dryers falling apart, trips to the emergency room, and unexpected home repairs. Having cash on hand could allow you to stay the course with far fewer worries.
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.