What is Liquidity?
If you had to name the most important element of a financial strategy, what would you name?
Many investors would pick goals like getting the best possible return on their money, avoiding risk to prevent losses or finding ways to minimize taxes.
While these are all important, liquidity is often considered to be the most important element of a financial strategy.
What is liquidity?
Liquidity is a description of how quickly an asset can be turned into cash. Money in a bank account is liquid because you can take it out and spend it immediately.
Real estate is not liquid because to turn a property into cash you need sell it, which can take weeks if not months.
“The faster an asset can be turned into cash,
the more liquid it is considered to be.”
Why is liquidity important?
Life can be full of unpredictable expenses. Your car could break down. You could get stuck with large medical bills. You could lose your job.
In all these situations, you’d need a fairly large amount of cash to get by. This is why it’s so important to have at least some of your money in liquid assets.
If some of your savings are liquid, you’ll be able to get some money out to deal with these expenses.
If all your money is tied up in long-term investments, you’ll either have to sell some assets at a loss to get money fast or rely on expensive, high-interest debt like a credit card.
Either choice will hurt your finances, so it’s better to keep some liquidity in your financial plan.
How much liquidity do you need?
A good rule of thumb is to have anywhere between three to nine months of living expenses in liquid assets for your emergency fund.
Good examples of liquid assets could be bank accounts, Certificates of Deposit (CDs) and money market accounts. You can take money out of these assets very quickly without taking a loss.
Once you get through your tough financial situation, you should try to replace this money so you’ll be prepared for the next problem.
All too often Americans get into serious debt because they don’t have enough liquidity in their financial plans. Be sure to make this important element part of your financial strategy.
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