Do you know the importance of liquidity in your investments? This information cannot be underestimated. As we have mentioned before, any portfolio, the ability to convert assets into cash quickly and without losing value. This is crucial for taking advantage of opportunities and dealing with financial contingencies. Maintaining an appropriate balance between liquid and illiquid assets is key to the success of a long-term investment strategy.
What is liquidity and why is it important?
If you are a beginner investor you should know what liquidity means, don’t worry, here we explain it to you. We refer to the ease with which an asset can be converted into cash without significantly affecting its market value. For example, having money in a bank account is very liquid because you can access it quickly and without its value changing. On the other hand, selling a house or land is not so liquid, because it may take time to find a buyer and you may have to accept less money than you expected.
Highly liquid assets, such as cash or Treasury bonds, can be sold quickly and with little or no loss in value. Conversely, less liquid assets, such as private equity investments, may take longer to sell and may require significant discounts to find a buyer.
The importance of liquidity
As we already know what it means to have liquidity, here are 3 main reasons why it is essential in your investments.
- It allows you to respond effectively to unforeseen situations, such as financial emergencies.
- It offers the flexibility to take advantage of investment opportunities that arise suddenly.
- Without adequate liquidity, you may be forced to sell assets at unfavorable prices, which will negatively affect your long-term returns.
How to measure the liquidity of your investments?
To measure the liquidity of your investments, it is essential to identify how much of your portfolio is made up of liquid assets and how much is made up of illiquid assets. As previously mentioned, liquid assets include cash, demand deposits, stocks in large publicly traded companies, and short-term government bonds. On the other hand, illiquid assets include real estate, private equity, and long-term corporate bonds.
Another way to measure our investments is with the liquidity ratio. It is a useful metric to evaluate how liquid your portfolio is. It is calculated by dividing your liquid assets by your total assets. A high liquidity ratio indicates that you have a higher proportion of assets that you can quickly convert into cash. This ratio is essential to ensure that your portfolio is prepared to meet short-term needs without compromising your long-term investment goals.
Maintaining an appropriate balance between liquidity and profitability
One of the main difficulties for investors is finding a balance between liquidity and profitability. In general, more liquid assets tend to offer lower returns, while less liquid assets tend to offer higher returns. Therefore, it is crucial that you determine what is the right level of liquidity for your personal needs and long-term financial goals.
Strategies to maintain balance
- Diversification: It is the key to the success of your investments. Distribute your portfolio between liquid and illiquid assets. This not only reduces risk, but also ensures that you always have access to funds when you need them.
- Contingency planning: As they say: “Prevent, rather than regret”. Establish an emergency fund that is invested in highly liquid assets. This will allow you to face unforeseen situations without having to liquidate other long-term investments.
- Periodic adjustment: Regularly review and adjust your portfolio to maintain an adequate level of liquidity, ensuring that you are not leaning too much towards low or high liquidity assets.
Risks of not maintaining adequate liquidity
- Selling in times of panic. If your portfolio lacks liquidity, you may find yourself in a situation where you need to sell assets in an unfavorable market, which could result in significant losses. This is a particular risk during periods of market volatility or economic crises.
- Missed opportunities. Lack of liquidity can also cause you to miss valuable investment opportunities. For example, if an excellent investment opportunity arises but all your assets are tied up in long-term investments, you may miss the chance to capitalize on it.
How to improve liquidity in your portfolio?
Consider reducing the proportion of your portfolio that is invested in illiquid assets, especially if you foresee the need to access cash in the short or medium term. This may involve selling part of your real estate investments or reducing your exposure to private equity.
Short-term government bonds and money market mutual funds are excellent options to enhance the liquidity of your portfolio. These instruments are not only highly liquid, but also offer relatively stable returns.
Although a more advanced strategy, the use of derivatives such as options and futures can help you manage the liquidity of your portfolio. These instruments can offer a way to gain access to cash without having to sell underlying assets.
The importance of liquidity in your investments is critical to maintaining the flexibility and resilience of your portfolio. A proper balance between liquid and illiquid assets will allow you to navigate both stable and uncertain times, ensuring that you can take advantage of opportunities and protect your capital against unforeseen events. By implementing strategies that allow you to maintain this balance, you will be better prepared to achieve your long-term financial goals.
