What’s your liquidity?

What’s your liquidity?

What’s your favorite liquid?

I like chocolate milk.  It is sweet and smooth.

I asked my daughter.  She said water, but she isn’t well acquainted yet (she’s 2).

Wait this is a personal finance blog, right?

Right. So when I say “What’s your liquidity?” I am referring to liquid in the financial sense of the word.

Liquidity is a term that is often thrown around in the financial services industry but is overlooked when it comes to personal finance.  With that being said, I believe that grasping the concept of liquidity will be helpful as you move along your financial journey.

What is liquidity?

When we say liquidity, we are not referring to a fluid of some sort.  Rather, liquidity can be explained as the “ease with which something can be traded for something else”.  Cash is known to be liquid while an antique car is not liquid (or illiquid).  Liquidity is also commonly defined as the ability to convert your assets into cash.

Liquidity in action

Let’s look at liquidity in action. If I had a collection of rare dress shoes valued at $2000 and I wanted to trade them for a $2000 laptop, I would have a hard time doing so.  Imagine walking into the Apple store with a suitcase full of shoes.  They would laugh me out of the store!  With collectibles (such as a collection of rare shoes) being an illiquid asset, I will have a very hard time trying to sell them. 
So after a month, I eventually find a buyer.  And he offers me $2000 in cash.  As result, I exchange an illiquid asset (the shoes) for a liquid one (cash).  The next day I go to the Apple store to with $2000 cash to exchange for a laptop.  In this instance, Apple is more than willing to engage in a transaction for the laptop.
Why?  Because you can exchange just about anything for cash.
Time is important

When it comes to determining liquidity, time is important.  Cash is very liquid because you can convert it into another asset of the same value very quickly.  Referring back to the example, a shoe collection will take a long time to find a buyer at the price consistent with the actual value.  If one wanted to convert an illiquid asset quickly, one will have to take a discounted price.

Why should you care?

Liquidity is of particular importance in emergency situations.  If you find yourself in a bad spot financially, you need to know what you could sell to get cash fast.  This is plan B if plan A (an emergency fund) doesn’t cover the bill.  Usually, in these type of situations, you don’t have the luxury to wait months to get cash.

Assess your liquidity
Like we did with net worth, you will need to group all your assets by levels of liquidity.  To determine the liquidity level of an asset, do some research not only on the market rate but also the “sellability” of an asset.
Consider the following questions:
  • Is there a market for this item?
  • Are there enough buyers within the market to purchase the item at face value (or close to it)?
  • Or is the demand low because the market over saturated with sellers?
Asset Rich and Cash Poor

If the answer is no to any of these questions, you may be in an asset rich and cash poor situation.  Meaning you have one or many valuable assets that you can’t convert to cash.  The catch is that certain assets (investments, house, etc.) appreciate in value and cash does not.  Increasing liquidity in this situation could mean that you are leaving money on the table.

However, cash poor people live close to the edge when it comes to their financial commitments.  One major incident could send your finances into a tailspin.  That is why it is important to have an emergency fund and some cash equivalent assets readily available.
Have you thought about your liquidity? Let me know your thoughts in comments section.