FOX Business' Stuart Varney and Lauren Simonetti analyze stocks during Friday's opening bell.
Liquidity is the ability to quickly turn your assets into cash. So what are the pros and cons of holding liquid investments?
"The more liquid an investment is, the faster it can be turned into cash without penalty or transaction costs," said Greg McBride, chief financial analyst at Bankrate.
HERE'S HOW INVESTORS CAN PROFIT IN AN INFLATIONARY ENVIRONMENT
On the contrary, fewer liquid investments tend to offer the prospect of higher rates of return, such as a certificate of deposit compared to a savings account, he said.
"Liquidity provides peace of mind knowing that you can cover unplanned expenses without having to take on high-cost debt or be a forced seller of assets," McBride said. "The trade-off is that, in exchange for safety and liquidity, this money will earn a lower rate of return that over time will trail inflation and result in a loss of buying power."
U.S. currency is pictured on a table. (iStock / iStock)
For example, a CD pays a higher rate of return, but McBride cautions it can be subject to an early withdrawal penalty that could negate whatever additional return was being earned compared to the savings account, where money could be withdrawn at a moment’s notice without penalty.
LIQUIDITY EXPLAINED: WHAT TO KNOW
What are some investments that offer liquidity?
According to McBride, the best liquidity is in federally insured bank accounts such as a checking account or savings account where the money can be withdrawn immediately. Money market mutual funds offer liquidity through the ability to transfer to another account, buy another investment or write a check from the account to cover a large expense, he said.
There may be age parameters to understand as well.
For example, McBride explained that if you’re under age 59 1/2, your retirement account isn’t very liquid even if it holds liquid investments because most withdrawals would be subject to potential taxes and a 10% early withdrawal penalty.
USA flag and American dollars. American flag blowing in the wind and 100 dollars banknotes in the background. (iStock)
GET FOX BUSINESS ON THE GO BY CLICKING HERE
Why is it particularly important at this point in time to have access to liquid assets?
The top two reasons for liquidity are having assets to pay your bills and an emergency fund for unforeseen and sudden expenses. McBride also recommended having access to some assets to take advantage of sudden investment opportunities.
"With such low interest rates, investors often think of liquid money as ‘dead money’ because of the low rates of return, but the rate of return should be measured in terms of buffering you from selling other assets, incurring high-cost debt and having sleepless nights when unplanned expenses arise," he said.
CLICK HERE TO READ MORE ON FOX BUSINESS
So in a nutshell, here is McBride's take on the pros and cons of liquidity:
Pros
- Peace of mind knowing that you can cover unplanned expenses
- No need to take on high-cost debt
- No need for the forced sale of assets in order to raise cash
Cons
- Lower rates of return
- Loss of buying power over longer periods of time as returns trail inflation
FAQs
Liquid funds are ideal for low-risk investors looking to park surplus cash for the short term. The biggest advantage of liquid funds is that it offers superior returns than bank deposits. But the returns on liquid funds is not guaranteed. This is the biggest disadvantage of liquid funds.
Why is it important for people to have enough liquidity? ›
We all have bills to pay, and having liquidity helps us to meet everyday cash needs and short-term financial obligations – whether we're talking about groceries, car payments, rent or mortgage. Emergency preparedness.
Is liquidity good or bad? ›
Liquidity is neither good nor bad. Everyone should have liquid assets in their portfolio. However, being all liquid or all illiquid can be risky. Instead, it's better to balance assets with your investment goals and risk tolerance to include both liquid and illiquid assets.
What are the negative effects of liquidity? ›
The repercussions of unmanaged or poorly managed liquidity risk can be severe and far-reaching. It can lead to financial losses from the sale of assets at depressed prices, operational disruptions due to inadequate cash flow, and reputational damage which can further exacerbate liquidity issues.
What are the advantages of good liquidity? ›
The main advantage of strong liquidity is knowing there are enough assets to cover unexpected emergencies, changes in demand and surprise expenses. It can also improve a business's credit score which will give you a greater chance of securing funding should you need it.
What are the cons of liquid assets? ›
However, there are also some disadvantages to liquid investments such as lower returns compared to illiquid assets, inflation risk, short-term investment focus, limited exposure to high-growth opportunities, and the need for careful assessment of individual financial goals, risk tolerance, and time horizon.
Why is too high a liquidity bad? ›
Substantial increases in liquidity — or ratios well above industry norms — may signal an inefficient deployment of capital. Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company's cash reserves are too high.
Why is low liquidity good? ›
High liquidity indicates a large number of participants and active trading, leading to smoother transactions and lesser price volatility. Conversely, low liquidity implies fewer participants and less trading activity, which can result in higher price volatility and trading challenges.
Why is liquidity good for the economy? ›
Cash is the most liquid asset, while tangible assets, such as housing, are less liquid. A high amount of liquid assets in the economy can boost asset performance, while a lack of liquidity can detract from returns.
Why is liquidity a problem? ›
A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash. For example, it is no longer able to pay its bills on time and therefore defaults on payments. In order to avoid insolvency, it must be able to obtain cash as quickly as possible in such a case.
Liquid assets can be quickly and easily changed into currency. Healthy liquidity will help your company overcome financial challenges, secure loans and plan for your financial future.
Is liquidity a problem? ›
Liquidity problems can happen to both individuals and businesses and pose a challenge to financial health. Liquidity it important. Insufficient cash to meet financial obligations can lead to late payments, debt and even jeopardise the survival of a business.
What are the advantages of liquidity in business? ›
Having liquidity allows companies to act quickly, capitalizing on favorable circ*mstances like investments, acquisitions, or surges in demand. 3. Surviving Downturns: Economic downturns and crises are inevitable. Businesses with strong liquidity are better equipped to weather these storms.
What are the disadvantages of liquidity ratios? ›
Liquidity ratios have some disadvantages that limit their reliability and accuracy. For instance, they are based on historical data, which may not capture future changes or trends. Also, accounting policies and practices can affect the amount of inventory reported on the balance sheet and the quick ratio.
What are the disadvantages of liquidity preference? ›
Limitations of Liquidity Preference Theory
In reality, the employment rate is not constant, and it is constantly changing. The second criticism is that this theory assumes a certain level of income. The third criticism is that this theory claims that it is either cash or investment in bonds.
What are the disadvantages of low liquidity? ›
Limited Investment Opportunities: Finally, low liquidity can limit investment opportunities for traders. In a market with low liquidity, there may be fewer opportunities to find undervalued assets or to capitalize on market inefficiencies. This can limit the potential returns for traders and investors.
