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Wednesday, February 24, 2016

Liquidity is a vital aspect of Your Portfolio

Liquidity is the ability to generate cash at a short notice. It is NOT about how wealthy we are, but how much cash can we pull out as and when needed. A well planned financial portfolio will account for liquidity as one of the critical parameters before deciding the investment target...Read on..

The market was down. His stock was also down, very much in line with the overall sentiments of the market. It seemed just the right opportunity to bring down the average cost for one of the blue chips that my friend was holding. I advised him to go ahead and invest more in his stock during this tumultuous time, follow the Rupee Cost Averaging principle, bring down the average cost of the stock, and reap the rewards later. He agreed wholeheartedly. 
It was just then, when he realised that he has no spare cash to invest. All his surplus was already invested, and it was difficult to take cash out from any of those investments, at least for the next 2 weeks. Well, in such times, 2 weeks can prove to be too long a duration not to miss out on the opportunity that the market was providing to bring down his average cost.

What my friend lacked was "Liquidity" of his investments. He had enough wealth, but almost none was liquid right now.

Liquidity is your ability to generate cash at a short notice. It is not about how wealthy we are, but how much cash can we pull out as and when needed. A well planned financial portfolio will account for liquidity as one of the critical parameters before deciding the investment.

Let us see 2 more cases that happened with me recently.
  • One of my school friends asked me for a financial advice recently. He wanted to know that why should he not invest in the Government Gold Bond scheme considering the fact that its returns are better than what Gold ETFs would give, is at par on taxation and is also very safe.
  • One of our readers sent us a query over email as to why they should not invest in NPS considering that they can save taxes on an additional Rs. 50,000 over and above the Rs. 1.5 Lacs limit under Section 80C.
Both the above arguments seem logical in the first go. But hold on. Both of them are missing out on a key parameter that we so often ignore, i.e. Liquidity. 

Most of us tend to invest our money considering some of the below key parameters in mind:
1/ Rate of Returns (RoI)
2/ Taxation
3/ Safety / Risk involved in investment

There is absolutely no doubting the fact that the above 3 factors are truly important for an investor. But one of the most critical factors that often gets ignored is the liquidity of our investment. It is perhaps the lack of our knowledge or the lack of importance we place on a factor like 'Liquidity' that we tend to ignore it.

Now, here is the fact. 
Liquidity remains the single most important factor if you have to continue to run a balanced portfolio through the ups and downs of a volatile market. It has been studied and proven that continuing to keep a balanced portfolio is the single biggest factor that influences your overall portfolio returns over a long term (10+ years). And since Liquidity is the most critical factor to run a balanced portfolio, we may ignore this critical parameter only at our own peril.

Investments with High / Medium and Low Liquidity

1) High Liquidity Investments

2) Medium Liquidity Investments

3) Low Liquidity Investments / Illiquid Investments

Consequences of ignoring Liquidity while planning your portfolio

Ignoring liquidity does much more harm than we can ever think of. I have personally been a victim of this. When you have a big ticket expense (planned or unplanned), lack of liquidity may force you to do one or more of the following:
1. Take loans at rates much higher than what you would like.
2. Continue to run an imbalanced portfolio thus diminishing your overall portfolio returns
3. Exit early / untimely from some of your existing investments, thus pocketing unfairly low returns.
4. Borrowing money from your relatives, friends or family. A slightly longer term lack of liquidity may impair your ability to pay back the borrowed money on time, thus even straining your relationships.

If any of the above consequences are unacceptable to you, then you must act decisively. You ought to use one or more of the strategies that we are listing down to improve liquidity of your portfolio.

Strategies We Can Use to Increase Liquidity in our Portfolio

1) Identify Liquidity as a Critical Parameter
Investments can be tuned to liquidity needs if investments are made with care. Look critically at Liquidity before you make your next investment move, especially in long term investments like NPS, PPF, EPF, SSS. Make sure that each investment is compared for liquidity along with other critical parameters like Taxation, Returns, Safety etc.

2) Create a Liquidity Calendar
Draw a calendar for liquidity and keep it updated. Other than the expenses that are met with your monthly salary, there may be special expenses that are likely to come in future e.g. your child's higher education admission, marriage etc. These expenses would need liquid money to be made available at a specific stage of life. A Liquidity Calendar will help you plan your portfolio investments better.

3) Understand the Liquidation Process
Understand the process of liquefying your investments. Some investments can be liquified online and that too almost instantly e.g. FDs, MFs, Stocks etc. At the same time, some may require physical presence at the bank or post office, and some may require a long procedure like selling off a real estate. Understand the Liquidation Procedure before you invest and then invest as per your Liquidity Calendar.

4) Create a contingency fund
Create a contingency fund (6-12 months of salary) which may fetch slightly lower returns but can be easily liquified. Remember that the contingency fund is a risk management tool. You may need a "planned" contingency fund for planned expenses like marriage and higher education. You will also need an "unplanned" contingency fund in case of medical or other life threatening emergencies.

5) Maintain good credit history. 
Maintaining a good credit history will allow you to get loans easily and quickly in times of need. This can potentially reduce some of your liquid money needs (and stress) in case of an emergency.

6) Laddering of FDs
If you have ample money put in Fixed Deposits, then the technique of laddering of Fixed Deposits can go a long way in providing you with the required Liquidity needs. You can read more about it here --> Ladder Your Fixed Deposits



Summary


The above strategies, when applied on your portfolio can not only ensure safety and security of your investments, but also give you levers for creating more liquidity for your portfolio. A highly liquid portfolio provides you with much higher returns in the long run by giving you the benefit to move around your investments easily to optimise your returns.


Like the article? 

Do not hesitate to share. It can make a positive impact on someone's life.

The book "From the Rat Race to Financial Freedom" has many such investment concepts explained in a very simple and uncomplicated manner, especially in the Indian context.


Cheers

Manoj Arora
elevate your life...

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