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 – firstname.lastname@example.org
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