investment: should an investor worry about the liquidity of his investment portfolio?


Should we be concerned about the liquidity of the portfolio? This question arose when a senior insisted that a reverse mortgage made their most important asset, their home, a liquid asset. How to argue this case?

Liquidity is the ability to convert to cash, at the fastest time and at the lowest cost. The important words to pay attention to are time and cost. Technically, each asset can be considered liquid. It can eventually be sold at a price that converts it to cash. I remember an intern asking me if liquid assets meant there were solid assets – we started a discussion about illiquidity.

If the conversion of an asset to cash takes an excessive time or involves a high cost to complete such a liquidation, we may qualify that asset as illiquid. Take for example gold jewelry. Would you call it a liquid asset? It can be sold to jewelers, who often agree to take what has been purchased with a seal of approval in their own stores. However, a high cost called costs and damages is recovered. So gold coins, gold ETFs, and gold bullion can be liquid, but gold jewelry is relatively illiquid.

The property too. It is large and bulky and cannot be sold easily. There are high costs and taxes associated with the sale. Typically, physical assets are less liquid than financial assets which can be divided, held electronically and sold in an open market at transparent prices and low cost.

When we value an investor’s portfolio, we look for different levels of liquidity. Absolute liquidity refers to assets that can be converted to cash on demand at no cost. The deposit in a savings bank is an example. There is no cost associated with the withdrawal and it can be done at any time. That is why he pays the lowest return.

At the next level is an investment in a liquid fund. A liquid fund simply shifts investor money from liabilities on the bank’s balance sheet to assets, at costs well below the bank’s interest margins. Since there is an active market for overnight and very short-term silver, liquid funds earn in this market and pass the returns on to an investor, after low and efficient costs (typically 0.10 – 0, 20%).

Unless the product has a foreclosure and requires one to remain invested for a predefined period of time, financial products are liquid. But they come with market risk, which means the liquidity seeker has to accept what the markets offer. Suppose an investor has invested most of their money in the stock markets. These are very liquid markets where the stocks held can be sold almost instantly at low cost. However, a crisis like the 2020 Covid pandemic can hit prices hard, pushing them down. An investor in need of urgent liquidity, also resulting from the crisis, will find that he can sell immediately, but the price he gets has been affected by the stock market crash.

Thus, a risky asset can offer liquidity, but the investor cannot rely on it if he has a foreseeable need for liquidity. The concept of an emergency fund as a first step in financial planning stems from these liquidity issues. Reserving an amount equivalent to six months of household expenses, in a low-cost, low-risk, and highly liquid product, allows the household to cope with any unforeseen events such as job loss or declining income.

The presence of assets can generate cash for a household through the loan-against-asset facility. Against the liquidation of an asset and the incurring of costs or the impact of market risks, one can use the asset as collateral and raise funds against it. Loans are available against gold, deposits, funds, bonds, stocks and owner’s equity. Unsecured loans such as credit cards and personal loans are also available to meet sudden cash needs, but they are relatively expensive.

Lending against an asset is a choice to be made if the investor does not like losing possession of the asset or is hesitant to replenish it once sold. The cost of the loan will be greater than the return on the asset, and lenders will apply a discount or margin to the market value of the asset. The higher the risk of the asset, the higher the margin.

This brings us to the question we asked at the beginning. A product like the reverse mortgage provides monthly income against the independent home. Does that make the house run down? The reverse mortgage is also a case of a loan against an asset. A retired investor who uses this option would be in a desperate position with no other asset to liquidate or deploy to generate income. It is not a routine or default choice.

It is not uncommon for households to have a disproportionate amount of wealth locked away in independent ownership. In many cases, it is the only trump card. This in itself is a risky proposition. It does not generate any income and its value cannot be converted into cash by a sale. These instances of being rich in assets and poor in cash are common. We know of elderly investors living in homes to which they are emotionally attached, but who have little income for their upkeep or for their own basic living comforts.

A better alternative to the reverse mortgage is the move. Selling the home can free up much-needed funds that can be used to move into a smaller home, retirement community, or suburb. Any funds saved after this reduction can be invested in financial assets to generate income. Investors do not exercise this choice because of social pressures, fear of new and unfamiliar and emotional attachment to their home.

Young investors tend to seek cash by trying to match their growing spending with their limited income, unless they are privileged. Older investors try to keep their assets profitable enough to fight inflation which increases their current spending. Measuring and managing portfolio liquidity is therefore essential at all stages of the investor’s life cycle. Take a look at your wallet and make sure you know how much is cash, and at what costs and expenses. Absolute liquidity generates the lowest return; absolute illiquidity keeps your wealth inflexible. Choose wisely.

(The author is president, Center for Investment Education and Learning)


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