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Why Liquidity is an Important Aspect of Your Portfolio

Planning your investment portfolio helps you allocate your savings into suitable investment avenues that align with your financial goals. When planning a portfolio, investors usually look at four key attributes in investment and saving plans – return potential, time horizon, tax savings and risk profile. But many tend to neglect liquidity, an important attribute that could have major financial implications.

May 2023

8 mins read

Understanding liquidity

In financial terms, liquidity is measured as the ease with which an asset can be converted to cash or its equivalent at its current market value. An asset is said to be liquid if it can be quickly converted to cash without affecting its current value.

For instance, the cash in your hand or at the bank is fully liquid. You can use it for buying or for investing whenever you want. On the other hand, real estate is said to have low liquidity, because selling a property can be more challenging, and if you want to sell it urgently, you might have to settle for a value lower than the actual cost of the property.

The three factors affecting the liquidity of an asset

Factor	Meaning	Effect on Liquidity
Time	The time taken to turn an asset into cash	The lower the time taken, the more liquid the asset
Conversion cost	The cost incurred in converting the asset into cash	The lower the cost incurred in converting the asset to cash, the more liquid the asset
Price fluctuations	The fluctuation in the price of an asset when converting it to cash	The lower the price fluctuation on conversion, the more liquid the asset

Why is liquidity important to your financial portfolio?

Liquidity is an important factor in financial planning, especially when it comes to emergency preparedness. As the pandemic has shown us, emergencies can inflict huge financial losses on households through illness, job loss etc. It’s important to have some liquidity in your portfolio to tide you over such emergencies. Here are some ways liquidity can come to your aid:

Gives you instant funds in an emergency
When an emergency strikes, you might need an instant source of funding. A liquid portfolio can provide an instant source of income by converting your investments to cash, that too without affecting their value. When you know that you have liquid funds in hand, you are financially prepared to face anything life throws at you.
Helps you avoid having to sell growing assets
A healthy mix of liquid assets in your portfolio ensures you don’t have to sell growing assets when an emergency strikes. In a situation when you need funds, you can simply sell your liquid assets and let the growing assets continue to accumulate wealth for you.
Saves you from getting into debt
Some debt like home loans can help you build assets. However, taking a personal loan or maxing out on your credit card limit during an emergency can be detrimental to your long-term financial health. Liquid assets help you handle temporary financial problems without resorting to debt.

How much liquidity is optimal?

There is no single prescription for the financial liquidity of your portfolio. The ideal liquidity depends on your monthly expenses, income, existing assets and liabilities, lifestyle preferences etc.

Here is an indicative table of how much liquidity may be required in your financial portfolio[3]:

Type of Income	Optimal Liquid Corpus
Predictable income	3- 4 months’ income
Moderately predictable income	5-6 months’ income
Erratic income	8-12 months’ income

How to build an ideal liquid portfolio

You can allocate your funds to different types of assets to achieve your financial goals and provide a degree of liquidity. Here's a comparative table that shows the liquidity of different financial instruments:

Asset	Degree of liquidity	What to keep in mind
Cash	Very High	Does not earn any returns unless the currency fluctuates in your favour
Savings Bank Account	Quite High	You earn interest income on liquid funds, but the interest rate is low Interest income beyond Rs.10,000 is taxable
Money market instruments like Treasury Bills, Certificates of Deposits etc.	High	Shorter maturity durations Relatively difficult to access for retail investors
Fixed Deposits (Banks, NBFCs and Post Offices)	High	Money is deposited for a specific tenure Premature withdrawal is available, but may attract a penalty Interest income above Rs.40,000 is taxable if your age is below 60 years Senior citizens can claim deductions on FD interest up to Rs 50,000 under section 80TTB
Bonds	Moderately High	Can be traded on the stock exchange There is a degree of risk in such trading as you might have to sell at a lower rate
Stocks	Moderately High	Can be sold whenever you want Returns have a tax implication but come with some tax benefits if the asset is held for 12 months or more The investment is subject to market-related risks
Exchange-Traded Funds (ETFs)	Moderately High	Can be traded on the stock exchange You might get a lower value on selling the ETF if the market is unfavourable
Liquid Mutual Funds	Moderately High	Returns from liquid funds attract tax There is an exit load on redemption within the first 7 days
Equity Mutual Funds	Moderately High (except ELSS schemes which have a lock-in period of 3 years)	Can be redeemed whenever needed Low risk compared to stocks due to portfolio diversification Might give negative returns if markets are bearish May offer some tax benefits if held for 12 months or more
Debt Funds (except liquid funds)	Moderately High	Can be redeemed at any time Return potential is lower than equity funds and attracts tax Long-term capital gain (LTCG) tax comes with indexation benefits
Precious Metals	Somewhat High	Gold and silver prices fluctuate LTCG tax comes with indexation benefit
Real Estate	Low	The selling process is long and involves complex legal technicalities There may be tax implications

Risk, return and liquidity

As you can see from the table above, an instrument with high liquidity may not come with a high return potential, or may have a high risk attached to it. On the other hand, an instrument with strong return potential and low risk may not come with good liquidity. It’s important to strike a balance in your portfolio between returns and liquidity, and always keep a substantial liquid portion handy to help you during emergencies.

Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.

Source:

1. https://economictimes.indiatimes.com/mf/analysis/how-liquid-is-your-investment-portfolio/articleshow/75242928.cms?from=mdr

2. https://www.myloancare.in/savings-account/interest-rates/

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