Liquid assets are investments that can be easily sold or converted to cash with minimal impact on their value. Liquidity in general is an important consideration in personal finance. An investor’s time horizon, risk tolerance, investment objective among other factors will assist in determining how much liquidity should be held within their portfolio.
Cash is considered the most liquid investment because you can use it almost immediately. Other assets, such as real estate and art, are considered illiquid as they can take longer to sell – and you may lose money on your original investment when you do find a buyer.
Stocks, corporate and government bonds, and other select investments, fall just below cash in terms of liquidity. These assets are typically in demand by investors, making them easier to sell if you need to.
There is a settlement period of “T=2” to consider with security transactions: meaning the day of the trade plus 2 business days to receive the cash when selling a security such as a stock.
What are liquid assets?
The following are the main types of assets, ranked in order of their liquidity, from more liquid to less liquid. Again, the faster an asset can be converted to cash without losing value, the more liquid it is considered.
Examples of liquid assets
- Cash in bank accounts, like checking accounts and savings accounts
- Stocks, bonds, money market funds, mutual funds, ETFs, T-bills and GICs (depending on their maturity dates), TFSAs, registered retirement accounts (RRSPs), but beware, liquidating these will trigger taxes or early withdrawal penalties
What are non-liquid assets, or illiquid assets?
The most popular types of non-liquid assets are real estate, vehicles, art, jewelry and collectibles. Like illiquid stocks, these assets can take longer to convert to cash and sellers run the risk of losing money during the transaction.
Think about selling a home when the real estate market is down. Or attempting to find a buyer for a vintage automobile.
Why does asset liquidity matter?
Asset liquidity is important to investors primarily for ongoing cash flow purposes and for use during financial emergencies.
For instance, in the event of a market downturn or financial crisis, liquid assets can be sold quickly – at or near full value.
On a more optimistic note, you may want liquid investments because you’d like to pursue a business opportunity or buy a vacation property. Similarly, liquid assets in a money-market account will enable you to jump on investment opportunities.
So is there a connection between liquidity and net worth? Not necessarily. If a person’s assets are almost entirely tied up in mansions, cars and yachts, they leave themselves vulnerable should an unforeseen event happen, even though on paper they appear wealthy
Liquid stocks vs illiquid stocks
Some stocks are more liquid than others. It really comes down to the difference in trading volumes, and the stock price you’re expecting to enter or exit a position.
Let’s start with liquid stocks, which can be loosely defined as stocks that are easily bought and sold at transparent market prices on leading stock exchanges. These marketable securities normally have no shortage of buyers, so selling them is relatively easy and quick, plus they tend to retain their value.
Think well-known, large-cap stocks which trade in high volumes and are consistently in demand from traders and investors.
Conversely, stocks that have fewer potential buyers are considered illiquid stocks, or non-liquid stocks.
Due to low trading volumes, it may take owners of these stocks longer to sell. More concerning, there’s the potential for the investors to lose a significant percentage of the stock’s market value. Most illiquid stocks, such as small-cap stocks or penny stocks, also have low average share prices, often in the range of $1 to $3.
It stands to reason that stock liquidity could decrease across the board when the stock market is in decline. Investors during this time will pull out of the markets and move their money to other asset classes, making it more challenging for owners of stock to liquidate their assets.
How does real estate investment compare to stocks, in terms of liquidity?
For some time now, the housing and commercial real estate markets have been performing well in most parts of Canada. Sales have been swift, with demand outstripping supply. However, an investor should never assume that real estate is a liquid asset. It may take weeks and months to sell what you have.
What are “cash equivalents”?
There are three main types of cash equivalents: savings accounts, treasury bills, or T-bills, and money market funds. Cash equivalents are often used for short-term investing. While deemed very liquid and safe, cash equivalents have delivered low rates of return over the past two decades.
Sidebar: What’s the liquidity ratio?
The liquidity ratio is an important consideration when planning for your short-term and long-term financial future. It determines your ability to pay expenses when faced with an emergency. It’s calculated by dividing your monthly expenses by the total amount of liquid assets, like cash or cash equivalents. Most financial advisors suggest a liquidity ratio between three and six, or the equivalent of three to six months of expenses in their emergency funds. This target may be different for individual investors and will depend on lifestage, financial objectives and risk aversion.
Liquid assets: The bottom line
Liquidity is a critical part of a healthy financial life. Every investor should plan on having some liquid assets, including liquid stocks, for emergencies, life goals and investment opportunities. But at the end of the day, the ideal balance of liquid assets and non-liquid assets is an individual preference, reflecting your age, and both your personal and financial goals.