If Your Assets Are Still Frozen, You Can’t Use Your Money
Every asset you have has four investment characteristics; growth, income, risk, and liquidity. Growth is how much money you make when you sell the investment. Income is the money you make while you own the investment. Risk is how likely you are to lose money. And Liquidity is how long it takes to actually put your hands on the money.
Even your checking account has these four characteristics. Your checking account has the characteristic of growth, it’s just the growth is zero percent. If you put in $50, you’ll get $50 back. Your checking account also has the characteristic of income in the form of minuscule interest, or no income if the account doesn’t pay interest.
Where your checking account shines, though, is risk and liquidity. Your checking account has no risk, being guaranteed by the U.S. Government. And your checking account is instantly liquid, since it is already cash.
As stated above, liquidity is how quickly you can turn your investment back into cash. A 1-year CD would be said to be illiquid for one year, just as a 10-year treasury note would be illiquid for 10 years.
Large-Cap stocks are extremely liquid investments because with the click of a mouse you can sell the stocks to a willing bidder on an open stock market. Small “Over The Counter” stocks, on the other hand, are far less liquid because so few people trade them it could take days to find an investor wanting to buy the exact company stock.
Liquidity isn’t, however, just the time it takes to convert an asset to cash. Liquidity also includes how long it takes to get the full market value for your investment. All investments can be turned back into cash in a matter of minutes. A 1-year CD can be liquidated at the bank for a fee. A brick of gold can be sold at one of those Cash for Gold stores for pennies on the dollar. I could even sell your family home in a manner of minutes by simply listing the house with a $50 price tag. (If anyone wants to take me up on that, I’ll probably be the buyer who purchases it in a manner of minutes.)
Liquidity is the Neglected Step-Child of Investing
A quick review of most financial media will offer plenty of information on investment growth and even investment risk. Investment income is often only cited in articles and broadcasts about bonds and real estate, but can often be overlooked in equities and other investments. Unfortunately, liquidity is almost never discussed.
Similarly, many investors don’t consider liquidity when making investment decisions. The lack of discussion and consideration of liquidity is why I think liquidity is often the most important investment factor to consider. Not because it is actually more important than the other three, but because it’s overlooked status means investors should make a conscious effort to focus on liquidity.
Why Liquidity is So Important
The goal of investing isn’t to make the most money possible. The goal of investing is to accomplish your other life goals. Every investment must have a purpose; a reason you are investing for. It could be to fund your retirement, to send a child to college, to afford the down payment on a home, or to buy a car. The true purpose of an investment strategy is to accomplish your goals.
When it comes time to accomplish a goal, the only investment factor that will matter is liquidity. Yes, your investment growth, income, and risk will all determine if you have enough money to accomplish the goal. But liquidity will determine if you can actually use the money.
When Liquidity is Lacking: Four Quick Cases
An investment with a poorly matched liquidity will force you to either postpone your goal or sell the asset for less than what it is worth. To help understand how a poorly matched investment liquidity affect your goals, here are four quick examples.
Your Emergency Funds
If you have built up an emergency fund, you likely have the money sitting in a savings account. You also may have become frustrated with watching thousands of dollars sit in the account and earn next to nothing. This could tempt you to invest in a safe investment like a 26-week U.S. Treasury Bill to get a little better interest rate.
Unfortunately, the money is there to help you a deal with an emergency, and emergencies tend not to schedule themselves on 26-week timetables. If you did invest in the treasure bill and then lost your job, your emergency fund wouldn't be available to help you pay your bills. As depressing as savings account interest rates are, you need emergency funds in an extremely liquid form like savings accounts.
Sending a Child to College
A couple looking to send their child to college might want to invest more aggressively as they wonder how to pay for the high cost of college. Investing in private companies through crowdfunded investing or a hedge fund can provide much higher potential returns.
The higher returns comes with not just higher risks, but also with significantly reduced liquidity.
Often times, these investments can take two years or more to exit from, depending on the terms of the agreement and whether you can find a willing buyer. If you’ve invested in private companies, your kid could have a degree before you can get your hands on the money you saved to pay for college.
The Retired Widow
This example comes from the Stacking Benjamins podcast. During a discussion of non-traded Real Estate Investment Trusts (REIT), the hosts gave the theoretical example of a seventy year-old widow being sold a non-traded REIT as an investment.
The problem: the REIT they were looking at required the money to be invested in the REIT for 15 years. And since the REIT is non-traded, it means finding another investor to sell to is nearly impossible. As O.G. put it, “She’ll likely be on the other side of the ground when she gets the money back.”
Most of Your Goals
Probably my favorite investment being pushed right now is timber farms in South American countries. People selling them as investments claim they are low risk, have incredible returns, and have numerous government incentives. What’s not to love?
Timber farms are my favorite investment not because they are great investments, but because the liquidity of the investment is a joke. A great, depressing joke. Remember, timber comes from trees. And until the trees are grown and cut down, there is no income from the investment. Reading through a prospectus you will find your money is locked up for 25 years or more while the trees grow.
Pay Attention to Liquidity
As you plan your investment strategy, make sure to consider liquidity as a core component of any investment you research. Not considering liquidity could turn your goals into merely dreams when it comes time to spend the money.
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Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at firstname.lastname@example.org