Liquidity matters. Whether it’s for a house down-payment, for a car repair, or for a medical bill, we will have costs that require cash in a short amount of time.
What is liquidity? Liquidity is the ease in which an asset can be sold without impacting it’s price. These are assets commonly held in a bank account or a brokerage account.
The more liquid the asset is, the easier it will be to sell it for it’s price.
The most liquid asset is cash. Cash is the exact value of it’s price, and is what is broadly used for liquidity purposes.
It tends to be our first line of defense to something that we need to pay for. However, it can be difficult to know what the right balance is in having cash held in a bank and brokerage account.
First Consideration
How much your lifestyle costs each month. Add up all of your usual expenses. If something were to happen to you, how many months of expenses would you want cash available for? 1 month? 3 months? 6 months? 12 months? There’s no exact number of months, as everyone’s circumstances are different. But between 6 to 9 months is common. From there, consider what short term goals there may be that would need liquidity.
Second Consideration
The accounts to hold your most liquid assets (e.g. cash, CDs, money market funds) in. A usual place to start is with a high yield savings account. Since these are FDIC insured, your cash is safe and not at risk of being lost, as long as it doesn’t hold more than $250,000 per account.
Third Consideration
Also, the costs of liquidity. Since the more liquid types of assets, cash and bonds, are tax inefficient, you will incur income taxes by holding these assets as opposed to other types of asset classes that are more tax efficient such as stock. That is simply because of their tax characteristics. This should not be a deterrence to holding liquid assets, but it should be a consideration when determining the amount to hold in liquid assets. After income taxes, the other cost of liquidity is ‘lost’ portfolio returns. It is critical to not have excess liquidity, as excess liquidity means your portfolio was not exposed to the optimal risk level you established for yourself when your started investing.
Next Step
Ready to take the next step and work with a fee-only CFP? Reach out to schedule a Discovery Meeting to learn more.