Understanding Liquidity

We spoke about liquidity while discussing the features of alternative investments. Let us now understand what it is and why is it important for a portfolio?

Liquidity is the ease or efficiency with which an asset or security can be converted into cash.

To put it differently, liquidity is the ease with which you can buy or sell an asset or security in the market. Cash is the most liquid asset because you can easily convert it into an asset of your choice.

Let’s take a quick look at the liquidity of the most common assets we know about:

As you can see from the above illustration, a range of products is available to any investor to build a portfolio. The most liquid assets have the least return, while the ones with lesser liquidity have the potential to pay a higher return. While holding cash gives you no return, keeping your money in a bank account gives you around 3% interest or even less (as of April 2021). On the other hand, assets that give you the most return are also the least liquid.

A portfolio needs to have a balance of all three categories mentioned in the illustration above. The percentage of allocation will vary from one person to another, depending on their liquidity needs. For example, for people who are less than 35 and are actively working, cash flow may not be a problem. They can decide to allocate most of their funds in fairly less liquid segments to earn higher returns.

On the other hand, for retired people, cash flow is a primary concern. Hence, they may decide to opt for cash, bank account and less risky investments such as bonds.

And this brings us to an essential concept related to portfolios – Risk. We will discuss all about it in the next section.

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