Short Answer: Wondering what is liquidity? It’s how quickly something of value can be converted into cash.
What is liquidity?
If you need money fast, how quickly can you turn something of value into cash? That’s how to define the liquidity of any asset.
Liquidity is a spectrum, with some assets being more or less liquid than others. To add another wrinkle, a very liquid asset should be able to convert to cash without an impact on its market price.
For example, if someone has a comprehensive Pokemon collection, it may be very valuable. However, it’s not very liquid. If they needed to sell it, it wouldn’t be very easy. It’ll likely take time to find the right buyer, or they may have to sell it off piece by piece. Additionally, if they’re under pressure for cash, they may settle for lower offers, missing out on the true value of the card collection.
Every item of value has some form of liquidity, but some more than others. When determining liquidity, consider:
- Can I get my money?
- How long will it take to get my money?
Range of liquidity
Understanding liquidity more about asking “How liquid?” instead of “What is liquidity?”
Assets come in a range of liquidity, from very liquid to less liquid.
Consider the following assets and their liquidity:
- Cash. This is the most liquid asset. In the case of an emergency, having cash on hand is helpful, as you can cover the costs as quickly as possible without losing its market value.
- Bonds. Treasury bills and bonds are especially liquid. These bonds are backed by the government and can be sold in the secondary market, even if they haven’t matured.
- Investments. Stocks, mutual funds, and ETFs trade on public exchanges, meaning they’re fairly liquid. Typically, you can get the cash in a few days. However, liquidity in stocks can be tricky. If the market is down and you need to sell, you stand to lose some of the asset’s value.
- Real estate. A home or other property is considered “illiquid” or not very liquid. If you were in a bind and needed the value of your home in liquid form, it’d take a while to sell, and if you’re under pressure, you may get less than market value.
- Fine art, jewelry, or antiques. Whether it’s a notable painting or specialty collector’s item, fine art, antiques, collectibles may be the most illiquid. To realize the market value, you’ll need time to find the perfect buyer willing to pay. Similarly, if you need to sell jewelry fast, you may take it to the pawnshop, where you’d likely net much lower than the item’s market value.
The above examples are just a sampling of assets and their liquidity.
Importance of liquidity
Figuring out what is liquidity can help you determine if your budget can handle an emergency or unexpected expense.
With the right liquidity balance in your finances, you’re less likely to take on credit card debt or another form of personal loan when an emergency crops up.
For example, say your car breaks down. The repairs cost a few grand, and you need to repair it as soon as possible to get to work. If you don’t have liquidity in your finances and have no easy way to get cash fast, you may take on credit card debt (or some tool like Afterpay) to pay for the repair.
On the other hand, if you have cash, or another highly liquid asset set aside for an emergency, you can pay for the car repairs quickly, without waiting for cash, taking on debt, or losing the market value of a less liquid asset.
Having liquidity built into your budget is an important part of financial planning. If you don’t have an emergency budget, consider setting a financial goal to set aside three to six months of living expenses in a liquid account.
Liquidity, in some form, in your finances can lend you peace of mind if and when an emergency strikes.
Extra Credit
How do I determine my liquidity?
Figuring out personal liquidity in your finances can help you prepare for emergencies. Create your own simple balance sheet of assets and debts. Rank them from most liquid to least. Do you have three to six months of highly liquid emergency savings?
Another way to tackle liquidity is by playing out the following hypothetical scenarios.:
- How would I cover expenses if I lost my job?
- How would I pay the medical bill for a broken leg?
- How would I cover the cost of a $1,000+ car repair?