Liquidity simply means how quickly an investment can be sold and cash can be realised. Ideally, each investment operation should begin with cash and conclude with cash. Liquidity plays a key role in most investment portfolios, and one should allocate some money to cash and near-cash assets to ensure adequate liquidity.
Before we get into how much of the portfolio should be invested in liquid investments and which investments qualify as liquid investments, let us first spend some time on why it is essential.
An investment is not an end in itself but serves as a means to achieve one’s financial goals. The money should be readily available to pay for daily needs as well as to deal with financial emergencies. Hence, we hold some money in currency notes, bank accounts and digital wallets. Some money has to be kept in liquid investments which can mature in the near term to pay for short-term financial needs – for example, paying for a car insurance premium due six months from now or paying for the school fees of a child for the next year. In addition to these, one must also be prepared for financial emergencies – be it an accident on the road or job loss. These may entail extra expenditure. Though adequate insurance can help manage some of these expenses, it may not address all of them.
To give a ballpark estimate, for most individuals, it is adequate to maintain an emergency corpus equivalent to six months of expenses. However, individuals in niche jobs or with unstable incomes should ideally keep 12 to 18 months of expenses in an emergency fund. An emergency fund consists of liquid investments. The allocation to liquid investments goes up if a household anticipates a high chance of cash outflow – for example, a household with senior citizens may want to keep a larger sum in liquid investments to deal with hospitalisations. The same is the case with families expecting the arrival of a child.
Here are a few tips for maintaining an emergency fund and other liquid investments:
Avoid equities: Though stocks, especially those of frontline blue-chip companies, can be sold quickly, they should ideally not be included as a part of an emergency fund. Equities can be volatile, and if a financial emergency coincides with a downturn in the equities market, the sale proceeds may not be adequate to meet the requirement.
Fixed deposits and debt funds: Ideally, an emergency fund should be held in bank fixed deposits and debt funds. Bank fixed deposits and debt funds investing in very short-term bonds (such as overnight and liquid funds) can be monetised quickly. They offer relatively predictable returns and are not impacted by stock market volatility. These factors make them ideal liquid assets to rely on in times of emergency.
Liquidity before returns: Many times, individuals frown at the idea of keeping money in low-return-generating avenues such as fixed deposits. However, they should always remember that the primary idea of maintaining an emergency fund and liquid investments is to meet sudden cash flow needs. Hence, liquidity and safety of capital should take precedence over the potential returns an investment can offer.
Investors should ideally keep reviewing their portfolios in the light of their financial goals and risk profile at regular intervals. They should accordingly decide and reassess their allocation to liquid investments. In times of uncertainty, one may want to increase the size of the emergency fund.
Also, if there are many financial goals to be achieved in near term – say within couple of years, then it makes sense to allocate adequate money to relatively safe and liquid investments.
