Liquidity in Personal Finance

Liquidity is pivotal in personal finance, yet it is often overlooked in favor of more glamorous topics like investing. However, understanding and managing liquidity is crucial for maintaining financial health and achieving long-term goals.

What is liquidity?

Liquidity refers to how quickly an asset can be converted to cash. Our financial lives depend on access to cash. Cash is king, whether it’s paper currency, figures in your checking account, or the ability to borrow it instantly with the swipe of a magnetized plastic rectangle.

The most common way to measure liquidity is your “personal liquidity ratio,” defined as cash and cash equivalents divided by monthly expenses. This represents how many months you could sustain the loss of your income.

Why do I need liquidity?

1. Cash Flow Management:
Liquidity ensures that you have the necessary cash to meet your regular expenses. Without adequate liquidity, you may struggle unnecessarily to cover essential costs like rent, utilities, groceries, or loan payments, leading to financial stress or accumulating debt.

2. Emergencies:
Life is unpredictable, and emergencies can strike at any time. Whether it's a medical issue, car repair, or sudden job loss, having liquid assets allows you to handle these situations without adding financial stress on top of it all.

3. Debt Management (Staying Out of Debt):
Adequate liquidity helps you stay out of debt by providing a cushion for unexpected expenses. Without it, you might rely on credit cards or high-interest loans, making it harder to achieve your long-term goals.

4. Financial Flexibility:
Liquidity gives you flexibility and lowers financial anxiety. It allows you to take advantage of opportunities such as investing in a new venture, helping a friend or family member, or making a career change.

What Constitutes Your Liquidity?

Liquidity refers to how easily an asset can be converted to cash without significant loss in value. Here's a breakdown of different types of liquidity:

Tier 1 Liquidity:

• Cash

• Checking Accounts

• Money Market Accounts

• Certificates of Deposit (CDs)

Tier 2 Liquidity:

• Liquid Investments in Taxable Brokerage Accounts: Stocks, bonds, and mutual funds can be sold relatively quickly, though they may fluctuate in value.

Tier 3 Liquidity:

• Home Equity Line of Credit (HELOC): A line of credit secured by your home, which can be drawn upon as needed. If you have sufficient equity in your home, consider setting up (but not drawing on) a HELOC.

• Credit Cards: While not ideal for long-term liquidity, they can provide short-term access to funds in an emergency.

• Roth IRA Contributions: Contributions (not earnings) to a Roth IRA can be withdrawn tax- and penalty-free, providing a potential source of liquidity. If you’re starting to build up an emergency fund, your Roth IRA can pull double duty. Hopefully, you won’t need to tap your Roth IRA so that these funds can be invested for the long term, but

• Safety Net: Support from family or friends can serve as an informal liquidity source in dire circumstances.

How much liquidity should I have?

Determining how much liquidity you need is a balancing act. You want enough to cover the unexpected but not so much that you miss out on longer-term opportunities. Like many things in personal finance, there’s no one right answer, only tradeoffs. The amount that makes one person comfortable might make someone else raise an eyebrow. That’s okay as long as you’re aware of the tradeoffs and it’s aligned with your overall goals.

Basic Rule of Thumb:
Aim to have 3-6 months of non-discretionary living expenses in liquid assets. The exact amount depends on your situation:

• Closer to 3 Months: If you have a dual-income household, your risk is spread so that you might need less liquidity.

• Closer to 6 Months: If you have a single income or mainly rely on one primary earner, you'll want more liquidity as a buffer.

Considerations for Larger Needs:

• Large Purchases or Investments: If you're planning a big purchase, such as a home, car, or investment, you may need to increase your liquidity.

• Life Changes: Starting a family, switching jobs, or launching a business are situations where more liquidity may be necessary.

• You own a business or work in a “boom/bust” industry: if your income is more variable, then having greater liquidity will reduce the financial stress on your family and give you the flexibility to invest in your business and withstand shocks and cycles.

Comparing Different Liquid Investments

• Checking Accounts: Highly liquid but typically offer low or no interest. Keep at least one month’s expenses in cash at all times.

• HY Savings Accounts: Offer slightly better interest rates, but they are often not as good as those in the money market.

• Money Market Accounts typically offer higher interest rates, FDIC insurance, and daily liquidity. However, you may need to move funds between your bank and an outside institution to find the best rates. Interest rates will fluctuate over time.

• Certificates of Deposit (CDs): Offer fixed interest rates but require you to lock in your money for a set period or pay a penalty if you redeem early. CDs are typically purchased directly from a bank, but “brokered CDs” can be bought or sold in secondary markets at prices above or below 100 cents on the dollar.

• Treasuries: Very liquid but subject to interest rate risk. If market interest rates rise, your bonds will lose value, but you will only realize that loss if you are forced to sell.

• Investment-grade corporate bonds: Offer slightly better interest rates than government bonds and are also subject to interest rate risk. Unlike government bonds, corporate bonds are also subject to credit risk (the risk that the issuer could go bankrupt).

• Equities: Stocks, ETFs, and mutual funds can be sold quickly but are subject to market volatility, and you may be forced to sell at an inopportune time. Not all stocks are equally liquid, either.

Examples of Liquidity Needs in Different Life Stages

20-Something:
Focus on building up to 6 months of living expenses in liquid assets. If you don’t have the cash flow to save for retirement and build up an emergency fund, consider funding your Roth IRA and using it to pull double duty.

Younger Families:
A dual-income family might feel comfortable with only three months of liquidity expenses, while a single-income family should aim for six months or more. Beyond that base level of tier one liquidity, additional liquid savings will give you the flexibility to change careers, send a struggling child to private school, or recover from an emergency.

Business Owner or Entrepreneur:
You may feel more comfortable with 1-2 years of liquidity to cover business expenses and personal living costs, especially in volatile industries. Greater liquidity will also allow you to invest when opportunities arise.

Retirees:
You’ve likely built considerable savings and no longer rely on a paycheck to cover expenses, so you may not need as much hard cash on hand once, especially after factoring in fixed income sources like Social Security or pensions. However, you may still value the peace of mind that having a sizeable emergency fund provides. Liquidity remains important to cover unexpected healthcare costs, help a struggling family member, or handle other emergencies.

Conclusion

Liquidity is like the oil in your car’s engine. Running an engine with too little oil risks overheating it and causing it to seize up. Liquidity provides financial stability and flexibility at all stages of life.

There’s no single answer to how much liquidity you should have, but there are still some reasonable guidelines. The key is to be aware of the tradeoffs and be intentional.