Liquidity is the ability to convert to cash, at the fastest time and at the lowest cost. The important words to pay attention to are, time and cost. Technically every asset can be argued to be liquid. It can be eventually sold at some price that converts it to cash. I am reminded of an intern who asked me if liquid assets meant there were solid assets—we launched into a discussion on illiquidity.
If converting an asset to cash takes an inordinate amount of time, or involves incurring a high cost to complete such liquidation, we can call that asset illiquid. Consider gold jewellery for example. Would you call it a liquid asset? It can be sold to the jewellers, who many a times agree to take what was bought with a seal of quality from their own shops. However, a steep cost called making charges and damages are recovered. So gold coins, gold ETFs and gold bars may be liquid, but gold jewellery is relatively illiquid.
So also is property. It is large and chunky and cannot be sold easily. There are stiff costs and taxes associated with the sale. As a rule physical assets are less liquid than financial assets that can be divided, electronically held and sold in an open market at transparent prices and low costs.
When we evaluate an investor’s portfolio, we look for various levels of liquidity. Absolute liquidity refers to assets that can be converted to cash on demand with absolutely no cost. The savings bank deposit is an example. No cost is associated with withdrawal and it can be done anytime. Which is why it pays the lowest return.
At the next level is an investment in a liquid fund. A liquid fund simply moves the investors money from the liability side of the bank’s balance sheet to the asset side, at far lower costs than the interest margins of the bank. Since there is an active market for overnight and very short term money, liquid funds earn from that market and pass on the returns to an investor, after costs that are small and efficient (typically 0.10 – 0.20%).
Unless the product has a lock-in and requires one to stay invested for a pre-defined period of time, financial products are liquid. But they carry market risks which means the liquidity seeker has to accept what the markets offer. Assume that an investor had most of his money invested in the equity markets. These are highly liquid markets where the shares held can be sold almost instantaneously at a low cost. However, a crisis like the Covid pandemic of 2020 can hit the prices hard, causing them to fall. An investor in need of urgent liquidity, also arising from the crisis, will find that he can sell immediately but the price he gets has been impacted by the market crash.
Thus a risky asset can offer liquidity, but the investor cannot lean on it if he has a forecastable liquidity need. The concept of an emergency fund as the first step in financial planning arises from these liquidity concerns. Keeping aside a sum equivalent to six months’ of the household’s expense, in a low cost, low risk, highly liquid product enables the household to tide over any unexpected event like a loss of job or cut back in income.
The presence of assets can generate liquidity for a household through the facility of loan against assets. Against liquidating an asset and incurring costs or being impacted by market risks, one can use the asset as collateral and raise money against it. Loans are available against gold, deposits, funds, bonds, shares and home owner’s equity. Unsecured loans such as credit cards and personal loans are also available to meet sudden needs for money, but they are relatively expensive.
Loan against an asset is a choice to exercise if the investor does not like to lose possession of the asset or is wary of building it back once sold. The cost of the loan will be higher than the return on the asset, and lenders will take a haircut or margin against the market value of the asset. Greater the risks of the asset, higher the margin.
That brings us to the question we asked at the beginning. A product like the reverse mortgage provides a monthly income against the self occupied home. Does that make the house liquid? Reverse mortgage is also a case of a loan against an asset. A retired investor who uses this option would be one in a desperate position with no other asset to liquidate or deploy for generation of income. It is not a routine or default choice.
It is not uncommon for households to have a disproportionate amount of wealth locked into the self-occupied property. In many cases it represents the only asset. That in itself is a risky proposition. It generates no income and its value cannot be converted to liquidity through a sale. These instances of being asset rich and cash poor are common. We know of elderly investors living in homes they are emotionally attached to but have little income for its upkeep or for their own basic living comforts.
A better alternative to reverse mortgage is relocation. Selling off the house can release much needed funds which can be used to move into a smaller house or to a retirement community or to a suburban location. Any funds saved after that markdown can be invested in financial assets to generate income. Investors fail to exercise this choice due to social pressures, fear of the new and unknown and emotional attachment to their home.
Young investors tend to scramble for liquidity trying to fit their expanding expenses into their limited incomes, unless they are privileged. Older investors try to keep their asset earning enough to fight inflation that expands their routine expenses. Measuring and managing liquidity in the portfolio is thus critical for all life cycle stages of the investor. Take a look at your portfolio and make sure you know how much is liquid, and at what costs and expenses. Absolute liquidity makes the lowest return; absolute illiquidity keeps your wealth inflexible. Choose wisely.
(The writer is Chairperson, Centre for Investment Education and Learning)