One of the terms that you might run across as you begin investing is “liquidity.” As you evaluate investments, and consider your overall financial situation, liquidity can be an important factor.
What is Liquidity?
Basically, liquidity is the ability you have to convert any asset into cash quickly. It is also an ability to buy or sell a security without affecting the asset's price. When you're talking about investments, your liquidity is basically how “easy” it is to buy and sell.
Cash is among the most liquid of assets, since you can use it to buy just about anything. Many stocks traded on the major exchanges are considered fairly liquid, since you can convert them into cash quickly and easily because there is almost always another investor willing to buy your shares.
Other assets might not be so easy to convert into cash. If you have a lot of your net worth tied up in your home, it might not be very easy to tap into that value—especially if you haven't build up a lot of equity. Other investment assets that are often illiquid include private company shares and certain debt instruments. You can't sell these assets without losing a great deal of money during times of economic difficulty, and sometimes there aren't buyers at all.
The Importance of Liquidity
While it isn't terrible to have some illiquid assets, it's vital that you have some of your wealth in assets that you can sell quickly if needed. Some illiquid assets have the potential for long-term gains, but you have to be in a situation where you don't need to sell them; you need to be able to hold onto them until the opportune moment, when they have appreciated in value—and there's someone willing to buy them.
Liquid assets are those that you can access quickly. In some cases, even cash can be somewhat illiquid. Think about a certificate of deposit. With a CD, your money is tied up for a set period of time. You can't access it early without incurring sometimes-hefty penalties. When you look at your asset allocation, make sure you consider how you will access some of your wealth if needed.
When you have liquid assets, you can get to them quickly, and use them easily. While I have a portion of my emergency fund in a high-yield savings account that I can access quickly, a large portion of my emergency assets are actually in a taxable investment account. I have the money invested in ETFs (which trade like stocks on exchanges and can be little more liquid than mutual funds, depending on composition and other factors). It takes a few days to get the money in my bank account when I have to sell something for an emergency purchase, but the even more liquid assets I have can usually cover during the gap in time.
As you put together an investment portfolio, don't forget to consider liquidity. And don't forget about liquidity in other areas of your financial life. You might tempted to buy shares in a private company, but when it comes time to sell, you might be hedged about by different rules. And what if no one wants to buy what you're selling?
Really consider you long-term financial goals, as well as your short-term goals. Think about your financial situation, and consider what you would do in an emergency. Would the investment tie up your assets to the point that you couldn't easily access your wealth if you needed it quickly? Do you have other, more liquid sources of wealth that you could tap if needed? Plan your investments and your finances so that you have enough liquidity to meet your needs and goals.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.