How much liquidity do you need in your investment portfolio? If something changes unexpectedly and you need cash right away, can your portfolio provide it, and with what consequences? Here’s a quick look at sensible liquidity planning.
Two definitions first
Liquidity is defined as the ability to withdraw money quickly (one day to one week) with no severe adverse investment consequences, such as short-term capital gains taxes. It can also be defined as being able to sell investments at fair prices, even in extreme circumstances.
Residential real estate, for example, is generally not very liquid by either definition. Few homes can be sold in a week, and when the market is distressed, getting what feels like a fair price may be completely out of the question.
How much is enough?
There’s no magic number that defines appropriate liquidity for all investors. It’s a personal matter related to your career, age, family and health. Osbon Capital portfolios are typically designed to provide a range of 10-30 percent liquidity, customized according to the needs of each client. It starts with a question: what is the maximum amount of cash you might need under special, extreme or unusual circumstances?
It’s basically a worst-case scenario question. What cash would you need if you lost your job, or experienced some other calamity? What cash flow would you need to get through the rough patch? Discussing this with clients we typically arrive at one of three answers:
- A fixed amount, say $250,000
- A percentage of your portfolio, say 10%
- A fixed amount of living expenses, say 8 months
Once the liquidity range is established, it is built into the ETF portfolio.
When tail wags dog
Extreme perspectives about liquidity can lead to portfolios that don’t make much sense. Here are viewpoints I sometimes hear and strongly counsel against:
- I need 100 percent liquidity, all the time
- I don’t want to sell anything that has gone down
- I need instant and safe liquidity – minutes, not days.
- If the market starts going down, I want out!
To meet these strict constraints, you would basically end up with a no risk, no return portfolio – one that doesn’t even keep up with inflation.
In truth, few people will ever need all their money at once. Once a rational liquidity level has been set, it can be built into a portfolio – in advance, with no surprises.
Max Osbon – email@example.com
- This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”
- “Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.
- Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.
- Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.
- This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.
- While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.
- Adviser does not endorse the statements, services or performance of any third-party vendor.
- Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.