Understanding Liquid Assets and Why They Are Essential for You
Should a recession come in 2023, households and businesses will want liquid or cash-equivalent assets that they can quickly convert into cash without loss of value to continue to pay their monthly bills and living expenses. Even in a strong economy, households may face emergencies or opportunities requiring exorbitant payments they can only make with a loan.
Liquid assets are a portion of a household’s net worth but differ from other assets as they provide convenience, fluidity, flexibility, and financial security, reducing worry about imminent financial pressures. These assets can help families better face emergencies without putting potentially high costs on credit cards.
What Are Liquid Assets?
Liquid assets are cash equivalents that can be converted into cash quickly at a low risk of loss in value. Having liquid assets means a business or household has funds free from financial risk.
Examples of liquid assets are savings and checking accounts, money market securities with short-term maturities, and highly liquid markets like Treasury bills and certificates of deposit.
These are typically financial assets facilitated by the market that can be bought and sold by many available buyers and sellers. Unlike household assets like a car or a home, these assets are closest to cash and provide fluidity, flexibility, and an enhanced ability to make timely payments for living expenses, save for current needs, and handle emergencies. Many people with limited liquidity use credit cards, potentially carrying significant balances at high-interest costs.
Even billionaires like Tesla founder Elon Musk, once the wealthiest man on earth, may find being asset-rich and cash-poor uncomfortable. According to SEC filings, Musk sold billions of Tesla shares in 2022 to help pay for the $44 billion Twitter acquisition and pay off personal debt.
The often-mentioned quote, “Cash is King,” reflects the reality that cash is a more valuable resource than other convertible assets that differ in their ability to provide liquidity.
Why Is Liquidity Important?
You may realize that liquidity is essential when you don’t have it (or lose it). Having cash has always been crucial, especially during economic downturns.
The US personal savings rate was 3.4% for December 2022, well below pre-pandemic levels. The Federal Reserve estimated that 40% of families could cover three months of living costs.
The inability to pay your bills on time, face an emergency, or pass on an opportunity that requires funding, results from liquidity risk. Without liquidity, you may pay for your needs with credit cards that carry toxic interest rate costs.
Having liquidity is valuable for opportunities when markets fall, and you can take advantage of market turbulence.
Liquid Net Worth Is a Realistic Snapshot of Your Cash Position
Net worth is a valuable benchmark for measuring your financial health at a particular time. It’s simply the difference between total assets and total liabilities. However, net worth focuses on all your assets, painting a less accurate picture of your cash position than liquid net worth.
Liquid net worth is a more realistic snapshot of your cash position, emphasizing liquid assets like bank savings, checking accounts, and financial assets. You may have a beautiful home or a vintage watch collection, but it will take time to sell those assets, potentially at a significant discount from their appraisal value. Your liquid assets should account for about 5% to 20% of your total assets, giving you financial flexibility.
In financial markets, securities, such as stocks and bonds, are bought and sold. Financial assets are more liquid than other household assets like cars and jewelry.
Market liquidity refers to the ease of selling financial securities at relatively efficient prices in their respective public markets.
Although securities are more liquid through electronic exchanges than selling other household assets, they vary according to factors like a bid-ask and daily trading volumes. The smaller gaps between the bid and ask prices and higher volumes indicate desirable market liquidity.
Examples of Liquid Assets
Liquid assets vary in their ability to convert into cash quickly. We’ll start with the most liquid assets and compare them to non-liquid assets.
- Cash is the ultimate liquid asset.
- Bank savings and checking accounts are readily available sources of cash as liquid assets. Their balances fluctuate with regular bill payments, ATM withdrawals, or transfers to other accounts, including an emergency savings fund. We can directly deposit our paychecks to make bill payments or contributions to our retirement or savings accounts.
- An emergency fund is a savings account essential for unforeseen costs when experiencing a job loss, medical needs, or pet surgery. Emergency funds help households avoid borrowing on credit cards or other loans.
- Money market accounts (MMAs) consist of cash-equivalent securities and are available from FDIC-insured banks and credit unions insured by the National Credit Union Share Insurance Fund (NCUSIF). MMAs pay higher interest rates than other savings accounts and may have check-writing privileges but may have minimums and additional fees.
- High-yield savings accounts offer higher annual percentage yields (APY) than traditional savings accounts but may have minimums and limit holders to six withdrawals per year before charging fees.
- Certificates of Deposits, known as CDs, may be bought for higher interest-earning ability than bank savings accounts. CDs require fixed-time deposits that must be left on deposit, typically ranging from six months to one, two, or five years. However, early withdrawals could result in penalties.
- Cash Management Accounts are alternatives to traditional bank savings accounts. Non-bank financial institutions, notably brokerages, Robo-advisors, and investment firms, offer cash management accounts. They offer interest-bearing savings and checking accounts and investment products. Your cash will likely be in FDIC-insured accounts as these firms partner with banks. They may have withdrawal limits that may impact their liquidity.
- Money market mutual funds (MMMFs) consist of money market securities like treasury bills and CDs offered by a mutual fund investment company instead of a bank. MMMFs are liquid assets but are not FDIC-insured like MMAs provided by banks. They offer higher interest returns than traditional savings banks but often have minimum requirements ranging from $500 to $5,000 to establish an account.
Bonds Vary in Liquidity
- The US Treasury issues Treasury bills, notes, and bonds, which vary in maturity and are rated triple AAA for the highest credit quality rating. They are highly liquid as they trade in very high volumes and have substantially higher liquidity than other municipal or corporate bonds. However, some treasury bonds, like Series I Government Savings Bonds, are liquid, but only after you hold the securities for the first year.
- Municipal and High-Grade Corporate bonds are less liquid than treasuries but benefit from active secondary markets. High-yield corporate bonds, or junk bonds, have substantially less liquidity and higher credit risk.
When investing in stocks, the daily trading volumes vary. Individual stocks may differ in liquidity characteristics. Large-capitalized stocks trade with higher volume providing greater liquidity than small-cap stocks with lower trading volumes.
The spread between the bid (buying price) and ask (selling price) is the transactional cost between the highest price a buyer is willing to pay and the lowest price the seller will accept. The bid-ask spread measures market liquidity, with smaller or tighter spreads, like for large capitalized stocks reflecting higher liquidity.
Mutual Funds and ETFs
Mutual funds consist of a diverse pool of securities like stocks or bonds. They are liquid as they may be easily bought and sold during the day. However, unlike an individual stock that sells at different prices throughout the trading day, mutual funds only trade at the close of the day at the fund’s net asset value.
Exchange-traded funds or ETFs have higher liquidity than mutual funds containing the same securities, as ETFs trade like individual stocks with different prices during the day.
Insurance products protect against potential loss, damage, illness, or death in return for premiums. For example, term life insurance is a type of life insurance of coverage for a specified timeframe. The death benefit is a relatively better liquid asset to the rightful beneficiaries than selling a real estate property before heirs receive the proceeds.
In contrast to term life, whole life insurance has a cash value component that the holder can tap during their lifetime, making it a more asset. There may be fees, and getting your money could take up to a month.
Assets with less liquidity are investments with longer-term horizons, like real estate or tax-advantaged retirement and college savings accounts for your household’s financial future.
Real Estate Property Investment
Outside of publicly traded REIT stocks, real estate investing is less liquid. Investing in non-public REITS and real estate syndication as a form of private equity is less liquid, with your money tied up, selling restrictions, and an average holding time for the project being about five years.
Selling your home or investment property can be challenging and is often hurt more by rising mortgage rates, tempering buyers’ enthusiasm.
According to the Federal Reserve, housing stayed on the market for 75 median days in January 2023. Once the sellers accept the offer, there are another 30 days until the property closes. That means it can take over 100 days for the sellers to receive the proceeds.
Private equity refers to capital investments in private companies that are not publicly available. They tend to be long-term investments with higher risk and return profiles than public equity, requiring more extended holding periods of several years with selling restrictions. The lack of a secondary market makes these illiquid assets.
Cars and other vehicles are unreliable liquid assets that lose their value when you can convert them into cash.
According to LendingTree, a car can lose up to 20% of its value in the first year due to depreciation and about 15% more each year for up to five years. Car types vary in depreciation, with the average five-year rate ranging from 9.2% for the Jeep Wrangler to 65.2% for the Nissan LEAF.
The June 2022 analysis of iSeeCars found the average new car takes 37.2 days to sell, while the average used car takes 52.1 days to sell, with the Subaru Crosstrek selling as the fastest car in 12.9 days.
Collectibles refer to items worth more than when businesses initially sold them for their rarity, beauty, or popularity. Categories include action figures, artwork, antiques, coins, comic books, dolls, sports memorabilia, snowglobes, stamps, toys, and Lionel train sets.
Collectibles would not be considered liquid assets. These items are challenging to sell, and their respective market’s supply and demand vary. They may have sentimental value to the owner that a buyer may not match.
Contributions for your retirement accounts are for the long-term future. Don’t count on your retirement accounts, notably 401(k)s, Roth IRAs, or traditional IRAs, as liquid assets. Avoid making an early withdrawal from these accounts before you turn 59.5 years old, as it may require you to pay penalties and taxes while losing some compounding benefits.
College Savings Plans
Like retirement accounts, your contributions for 529 college savings plans and Coverdell ESAs are for your long-term needs in paying for college or K-12 tuition expenses. Eligible expenses are educational costs, including tuition, fees, textbooks, supplies, computer equipment, and room and board.
Suppose you don’t use your 529 for eligible expenses. In that case, nonqualified withdrawals may result in a 10% penalty and will be subject to federal and possible state income taxes on investment gains in the account.
The 401(k)s or 529 college savings accounts are not liquid assets. They are long-term assets designed for your financial future. Unless you are 59.5 or older, withdrawing money from your 401k or IRA plans will result in 10% penalties and potential tax liabilities while losing some compounding benefits.
Health Savings Accounts (HSAs)
Some employers offer tax-advantaged HSAs as special savings accounts for people with high-deductible healthcare plans. Employees make tax-deductible contributions for eligible medical expenses, and employers may contribute to the account. As with other tax-advantaged accounts, withdrawal restrictions and tax payments may exist.
In 2023, individuals may contribute up to $3,850 per year, and families can contribute up to $7,750 per year. Withdrawals for nonmedical needs will face penalties and tax payments. The employee invests in HSA funds, and money grows tax-free. Eligible withdrawals are for medical expenses limited per year for individuals and families.
You can withdraw money when you reach 65 for nonmedical costs without penalty but will need to pay income taxes.
Equity Compensation Plans
Your equity compensation plan is a valuable part of your company’s benefits, provided as an incentive to work and remain long-term with the company. There are many different kinds of such assets, like employee stock options, employee stock purchase plans, employee stock ownership plans, and restrictive stock units. They vary in how they benefit employees, but their respective drawbacks, include vesting restrictions and different tax treatments, which make them non-liquid assets.
Inheritance From an Estate
Inheritance from an estate depends on the property being distributed to heirs. Non-probate assets include cash, money market, stock, and insurance accounts and pass directly to designated beneficiaries outside the will or trust and the probate process.
Those assets are far more liquid and received more quickly than probate property distributed according to the will or a trust which faces probate issues among family members. If you are divvying up properties that need to be sold and split among heirs, those assets are less liquid.
Some families may engage an auctioneer to hold estate sales to sell items not indicated in the will. These assets may raise some money but sell at deep discounts to their appraised value.
Benefits of Having Liquid Assets Convertible Into Cash
- Provide financial security so you can sleep better at night.
- Help address economic changes, like higher inflation or a recession.
- You can better face emergencies and other unexpected events.
- Give you the convenience of having cash instead of high-interest credit cards.
- Give you money for potential opportunities like investing in a market downturn.
Downsides of Having Too Much Cash
- Cash or cash equivalents generate zero to low returns.
- There is an opportunity cost of keeping too much cash, losing potential gain from cash alternatives.
Liquid assets are a portion of your assets that can convert quickly into cash and provide a household with flexibility and financial security when there are emergencies or opportunities you wish to leverage. You’ll sleep better at night when you can pay your bills, even when there is high inflation or a recession.
This article originally appeared on Wealth of Geeks.