Welcome to the final installment of our third-quarter blog series covering various aspects of risk management. Today, we are exploring a fundamental element of financial planning that has significant implications for your daily life: the value of liquidity.
What is Liquidity?
To start, it will be helpful to define liquidity. In the realm of financial planning and wealth management, liquidity refers to how easily and quickly an asset can be converted into cash without experiencing a reduction in value. The most liquid asset is cash itself. Other highly liquid assets include publicly traded stocks, most ETFs, and open-ended mutual funds. On the flip side, examples of illiquid assets include privately held businesses, real estate, and collectibles.
Why is Liquidity Important?
In today’s world, we no longer engage in barter transactions. When you have a financial obligation to meet, whether it is a bill to pay, a purchase to make, or an unexpected expense, the other party typically expects payment in currency. This underscores the vital importance of having a significant portion of your assets in liquid form.
Consider this scenario: you encounter an immediate spending need, and your liquid assets fall short. You are left with two choices – going into debt or liquidating illiquid assets. Unfortunately, converting illiquid assets (like real estate or business interests) into cash can be a complex and costly process. It may take weeks or even months to sell, often incurring substantial expenses like realtor commissions, legal fees, and financial institution fees. In urgent situations, you may have to sell at less-than-optimal prices.
When Might You Need Liquidity?
The saying “cash is king” holds true in many financial scenarios. You may require liquidity to cover a variety of situations, including:
- Tax Bills: Tax obligations can arise unexpectedly, and having cash on hand ensures you can meet them promptly.
- Planned Purchases: Whether it is a dream vacation, a new car, or a home renovation, having readily available cash allows you to make planned purchases without resorting to debt.
- Unexpected Expenses: Life is full of surprises, and some of them come with financial burdens. Liquidity helps you navigate unexpected emergencies without selling assets at a loss or incurring debt.
- Estate Settlement: When settling an estate, cash is often required to cover expenses such as taxes, legal fees, and other costs. Illiquid assets often need to be valued, incurring additional expenses, and potentially requiring a sale at below-market prices if there is not enough cash available.
Recognizing the pivotal role of liquidity in your financial plan is vital. It not only provides peace of mind in handling everyday expenses but also ensures you can navigate unexpected challenges and estate matters with financial flexibility. If this blog has sparked any questions or if you require further guidance on optimizing your financial strategy, the Master’s team is here to assist you!