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What Is Liquidity, and Why Should You Care?

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

Are your investments liquid or illiquid? When a holding is liquid, you can sell it for a fair price whenever the market in which it trades is open for business. If it’s illiquid, you can’t.

Cash and cash equivalents (such as bank accounts and T-Bills) are the most liquid assets of all. At any time, you can typically find somebody who will gladly give you something worthwhile in exchange for your cash.

At the other end of the spectrum, some investments are highly illiquid, which means your ability to trade in and out of them whenever you please is limited.

For example, many hedge funds and similar closely held vehicles may impose lockup periods, during which you are prohibited from selling your investment. You may be prohibited from withdrawing any of your money until you’ve owned the holding for a period certain, and your ability to withdraw funds after that may be limited to specific windows of opportunity such as once per quarter or twice per year.

Other examples of illiquid “investments” are annuities and cash value life insurance policies. These products can impose significant surrender charges and limit your withdrawal rights. So, buyer beware – be sure to read all the fine print carefully before investing in these complicated instruments.

Also, normally liquid investments can become illiquid under duress. There’s a saying in the markets that liquidity is like oxygen. You don’t notice you need it until it’s gone.

To cite an extreme example, during the September 11, 2001, terrorist attacks, the New York Stock Exchange and NASDAQ markets did not open for business that Tuesday; they remained closed until the following Monday. For four days, investors could not trade on either exchange, rendering many investment portfolios temporarily illiquid.

Individual securities and sectors can also shift dramatically from liquid to illiquid, especially if investor panic sets in. An example is when the bottom dropped out of the collateralized debt obligation market in 2007, contributing to the subsequent global financial crisis.

Between these extremes of highly liquid/illiquid holdings are many familiar investments. Mutual funds, exchange-traded funds (ETFs), stocks, bonds, and similar publicly held, exchange-traded securities are typically relatively liquid. They don’t flow in and out of your accounts as freely as cash, but even in turbulent markets you can usually sell them in a same-day transaction. (Mutual funds trade once daily at the end of the trading day. Individual securities and ETFs trade at prices that fluctuate throughout the day.)

It’s also worth noting, that some investments can be more (or less) liquid, depending on how you hold them. Real estate is a prime example. If you own property directly, it’s relatively illiquid. Even in a stable market, it can take days, weeks, or even months to sell real estate once you’ve listed it.

A non-traded Real Estate Investment Trust (REIT) may be at least as challenging to unload whenever you please. Typically, the non-traded REIT’s board – not you – will decide when and how trading is permitted. The same is true for most private real estate partnerships and LLCs.

On the other hand, a publicly traded REIT mutual fund or ETF is usually as liquid as any other mutual fund or ETF. Even though the fund’s underlying holdings may be relatively illiquid, you can usually sell your shares in that fund whenever public markets are open for business.

Bottom line, cash and cash equivalents are the closest you come to having a completely liquid asset. This means it’s important to have plenty of it on hand to cover near-term spending needs. We recommend budgeting for expected expenses as well as the inevitable surprises. However, cash will only take you so far. It tends to lose rather than gain worth over time, as inflation eats away its spending power.

We suggest managing liquidity as one consideration among many, achieving a balance that’s right for you. For the record, each holding in Align’s managed portfolios is highly liquid. We can typically sell any position on any day that the financial markets are open. We operate this way because we have learned to respect the value of liquidity. Remember, liquidity is like oxygen – one doesn’t appreciate it until it’s gone.

Could you use some assistance making these determinations? We’re here to help!