Oran Hall | Value of liquidity to personal financial planning

Liquidity plays a critical role in personal financial planning. It affects returns on investment, gives a portfolio balance, provides funds when needed, is influenced by market conditions, and varies by type of financial instrument. Ideally, every person needs to have liquid financial resources.

Liquidity is the ease with which a financial or other type of asset can be converted to cash without negatively affecting its price.

Liquidity varies significantly among asset types. Cash is the most liquid asset. Savings accounts are quite liquid as financial institutions put few, if any, hindrances in the way of account holders wishing to withdraw their funds. Fixed deposits, being for agreed periods of time, are less liquid generally. Thus, cash and near-cash instruments are quite liquid and do not cause the holder of the asset to lose principal. Their returns are low, however, being zero in the case of cash.

Investment instruments vary in their level of liquidity and returns. Unit trust and mutual investments are generally quite liquid although they may be invested in instruments that are not themselves liquid. Although redeeming them does not mean getting same-day payment, the instructions to surrender the instrument can be given to allow payment to be received when the funds are required.

The returns and the level of fluctuation in the prices of unit trust and mutual fund investments vary. There is hardly a chance that those that invest in the money market will cause investors to experience any capital loss. Those that invest in long-term fixed-income securities may experience temporary declines in value when interest rates rise but see increases when interest rates fall. Nevertheless, their higher returns compensate.

Similarly, the value of unit trusts and mutual funds that invest in equities and real estate also fluctuate, but they have very good potential for significant long-term positive returns.

By contrast, money market instruments – those maturing in a year or less – hold their value well. Their term to maturity may vary from a few days to one year. The shorter their term, the more liquid they are. Investing in a way that matches maturity to when the funds are needed is the preferred approach.

Long term fixed-interest securities, such as bonds and debentures, are different. Their prices tend to fluctuate with changes in interest rates, but they mature at face value and generally generate higher returns. To liquidate them before their maturity date is to risk losing capital if interest rates at the time they are being sold are higher than at the time of the initial investment. The opposite is true if interest rates move in the opposite direction.

Bonds and debentures lose some liquidity because they tend to trade on the over-the-counter-market and not on established exchanges. Much depends on the ability of investment dealers to find interested buyers and at prices that may be satisfactory to both buyer and seller.

The liquidity of preference shares is constrained by the size of our market although there has been steady improvement in recent years. The quality of the instrument, as in the case of bonds, also bears on the demand for and thus the liquidity of the instrument.

The liquidity of ordinary shares rests on the market as well as on the security itself. The more buyers and sellers there are of a stock, or any other type of asset, the more liquid it is and the more controlled price movements are. Some ordinary shares are limited in supply because they are held tightly by a few investors, and in other cases, the issued shares are relatively few. When they trade, prices tend to move significantly.

Liquid stocks are those that trade actively and in good numbers. Their price movement may or may not be significant. Quality matters, for while the better stocks trade actively, the weaker ones may be less liquid even in a buoyant market.

Tangible assets like real estate and collectibles like high-quality art are generally less liquid than the others. Often, it requires much more money to participate in the market and, real estate, especially, requires more time for the legal transfer of the asset to be completed.

Market conditions have a very strong influence on how easily an asset can be converted to cash. Using ordinary shares as an example, it can be difficult to sell even good quality stocks when the market is down. Beyond that, when trading does occur, the price may be on the low side.

A well-organised and effective personal financial plan cannot just focus on returns. Liquidity needs at various points in the plan must be central to it while bearing in mind that the most liquid instruments are the ones must likely to give the lowest returns but the ones which are generally the safest.

Liquidity is required to take care of a wide range of needs, including the following: living expenses including during retirement, settling estates, acquiring tangible assets, taking advantage of investment opportunities, covering emergencies, paying taxes, paying debt, and paying insurance premiums to provide insurance coverage – which itself can provide meaningful liquidity at times of significant loss.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com