The Importance of Liquidity and Liquid Assets
A Lesson from September 11th About Risk Management
In the aftermath of September 11, 2001, terrorist attacks in New York City, the American financial system was shut down for four incredibly long days. With stock exchanges closed, investors learned the importance of liquidity after they temporarily lost access to cash and investments. They were not guaranteed the ability to sell their stocks or other securities whenever they wanted and, in fact, could be forced to sit on them indefinitely without knowing what their quoted market value would have been.
Now almost 16 years later, the lesson remains timeless. Namely, investors should remember one important lesson: at least some portion of your net worth should be kept in liquid assets. That liquid portion has one primary job and that job is to be there when you reach for it. Earning a return is only a secondary, less important factor. However, I'm getting ahead of myself. Let's start at the beginning and focus on defining liquid assets then jump into an overview of how they might play into an investor's broader liquidity picture.
What Are Liquid Assets and How Can I Store Them?
The term liquidity refers to how fast something can be turned into cold, hard cash; the kind you stick in your wallet or cash exchange for something else. Liquid assets are those that are thought to be turned into cash or purchasing power immediately.
On one end of the scale of all assets are the dollar bills and coins you have stuffed in a cookie jar or mattress at home. These are the most liquid assets, meaning you can immediately spend them, but are the least safe because they can be destroyed by fire, misplaced, or stolen.
On the other end of the scale are assets such as real estate, which can take months or even years to convert into cash. When it comes to storing your liquid assets, here are a few of the most common places people choose to keep their cash:
In most cases, depositing your money in a bank is considered extremely safe. The reason? America's banks have not been frozen since 1933 when Roosevelt declared a "banking holiday" which lasted three days, and it seems relatively unlikely such an event would happen again in the near future. Money market funds can cause problems because in the event yours is administered by a mutual fund company, you may lose access to your cash if the financial markets shut down, which is precisely what happened to many investors on September 11th.
For emergency purposes, you should not consider stocks, bonds, mutual funds, annuities, or insurance policies as liquid assets. In addition to normal market fluctuations, these investments may become completely illiquid if the exchanges are closed, meaning good luck getting your hands on them.
Why You Should Keep Liquid Assets on Hand
Even if you don't own any investments, you still need a cash reserve. Once Manhattan was shut down following the terrorist attacks, many businesses could not operate. In some cases, employees were not paid for several weeks, leaving them without a source of income.
The United States came close to a liquidity crisis in 2008 and 2009 in the midst of the Great Recession. Some professional investors were rumored to be calling their spouses and warning them to go to the ATM and pull out as much money as they could get in case the banks weren't open for weeks or months.
What if there was a tragedy or extraordinary event in your area and you suddenly couldn't report to work?Taking the scenario one step further, what if such an event caused your company to run into tough financial times and it either closed its doors or started laying off most of the workforce?
How would you survive? If you had realized the importance of liquidity, you would be able to stay afloat for at least several months using your cash reserves. You could have purchased groceries, negotiated with neighbors, or bartered for goods using your emergency liquidity. Liquidity matters. Liquidity is important. It is a safety net for you and your family.
What Degree of Liquidity Should an Investor Consider Maintaining?
The level of liquid assets you should keep on hand largely depends upon your estimated monthly expenses and other personal factors you should discuss with your financial planner or investment advisor. In all cases, you should be able to support yourself and family for at least a month or two; most financial planners agree that six months is ideal.
It's important to remember that national emergencies are much less likely to happen than personal emergencies such as car repairs, layoffs, washer and dryers falling apart, trips to the emergency room, home repairs, etc. Having cash on hand could allow you to stay the course with far fewer worries.
If you are interested in this topic, you might also want to read How Much Cash Should I Keep In My Portfolio? to get a general idea of how cash can play a strategic role in asset allocation.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.