Understanding asset liquidity

Are your investments liquid or illiquid? When a holding is liquid, it simply means you can sell it whenever the market in which it trades is open for business, without losing your proverbial shirt in the exchange. If it’s illiquid, you cannot sell it, at least not for anything near what it’s worth.

Degrees of Liquidity

Cash and cash equivalents (such as checking or savings accounts) are the most liquid assets of all. All day, every day, you can almost always find somebody who will gladly give you something relatively 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 strictly limited.

For example, certain private placements and similar closely held vehicles may routinely 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 at least a year, plus your ability to withdraw funds after that may be limited to specific windows of opportunity such as once per quarter or twice per year.

Also, normally liquid investments can become illiquid under duress. As Ben Carlson observed on his Wealth of Common Sense blog, the following adage applies so well, it’s become a bit cliché: “Liquidity is like oxygen. You don’t notice that you need it until it’s not there.”

To cite an extreme example, during the September 11th 2001 attacks, the New York Stock Exchange and NASDAQ markets did not open for business that Tuesday; they remained closed until the following Monday. During that time, investors could not trade on either exchange, effectively rendering most of their investment portfolio illiquid for those four days.

Individual assets can also shift dramatically from liquid to illiquid, especially if investor panic sets in. An example is when the bottom dropped out on the Collateralized Debt Obligation (CDO) market in 2007, contributing to the subsequent global financial crisis. More recently, a March 2023 bank run at Silicon Valley Bank rapidly escalated into three significant U.S. bank failures, leaving depositors’ assets in limbo. Had the U.S. government not taken extraordinary action to protect those deposits, the impact could have been even worse.

Finding Middle Ground

Between these extremes of highly liquid/illiquid holdings, you’ll find most of the investments that are most familiar to you. Mutual funds; exchange-traded funds (ETFs); stocks and 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, some investments can be more or less liquid or illiquid, depending on how you hold them. Real estate is a prime example.

• If you own a piece of property directly, it’s relatively illiquid. Even in a stable market, it can take days, weeks, or months to sell your property once you’re ready to do so.
• 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.
• 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.

It’s worth noting, an asset’s liquidity – or lack thereof – is usually just one consideration among many when selecting particular investment vehicles for your portfolio. For example, some low-duration private real estate offerings may offer a helpful hedge against inflation, as financial author Larry Swedroe describes here. If the rest of your portfolio is liquid enough for your needs, you may choose to deliberately accept some liquidity risk when warranted, to strengthen your portfolio’s overall potential performance.

Liquidity: A Part of the Plan

Bottom line, cash (and cash equivalents) is the closest you come to having a completely liquid asset. This means it’s important to have enough of it on hand to cover near-term spending needs. We recommend budgeting for expected expenses as well as the inevitable surprises.

That said, because hard cash isn’t the only way to incorporate liquidity into your life, you may not need quite as much of it as you might think. In addition to cash reserves, you may have access to various lines of reasonably priced credit available to tap during troublesome times. For example, there are home equity lines, account margins, and traditional bank loans. You also may be able to borrow from your future self by taking out a loan from your 401(k) account (as long as you’re committed to paying it back on a timely basis).

Basically, it’s all about striking the right balance. Some cash is good. But if you sit on too much of it, inflation can eat away at your overall spending power. A degree of illiquidity is also beneficial, helping you remain as fully invested as possible in markets’ future expected returns. But you don’t want to tie up too much of your wealth, without enough cash or credit to see you through a liquidity crisis.

As you seek the balance that’s right for you, we suggest managing liquidity as one consideration among many. Maintain enough liquidity to ensure you’re never forced to permanently unload a less-liquid investment just to get at the cash. Accept a degree of illiquidity in your soundly structured portfolio, to judiciously seek premium market returns over the long-term. Understand when illiquidity is essential to pursuing higher returns, versus when you’re just taking on extra risk, without much else to show for it.

Once you’ve arrived at the level of liquidity that makes sense for you, you’ll be best positioned to go with the flow, come what may in the markets ahead of us.

This article is provided by Kaufman Rossin Wealth, LLC, an SEC registered investment adviser. Registration with the SEC does not imply a certain level of skill or training. The Firm can only conduct business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. This article is provided for informational purposes only and should not be considered personalized financial advice. Investors are encouraged to discuss any questions they have about the contents of this article with their financial services professional.