Today, I want to talk about a word in finance that is often misunderstood and/or ignored – liquidity.
There is a language of finance, and liquidity is one of those words that can be difficult to describe; it’s much like one of those words or phrases in Spanish or French that just doesn’t translate well into English.
We hear things on the news about how the Federal Reserve is “injecting liquidity into the system,” or maybe we read an article about how “liquidity issues” led to the demise of a certain hedge fund or family office.
You realize liquidity serves an important role, but maybe you don’t exactly know how it applies to your situation. Even a quick dictionary search doesn’t give you much clarity.
So, let’s discuss how this mysterious concept of liquidity applies to you personally and how crucial liquidity is to your personal financial plan.
But first, let’s talk about one of my pet peeves – cash-only businesses.
I mean, I get it – the credit card transaction charges dip into your margins as a business, so you’d rather take cash than debit or credit. But here’s my solution, just charge a little bit more. Now, if you are doing it to avoid claiming some of these transactions on your taxes, then I am even more annoyed.
Let me set the scene for you. It’s a Saturday afternoon, and both kids go down for a nap – I have a short window of time to myself, so I head out to get my haircut. My hope: a short wait time, quick haircut, back home for some SportsCenter, and vegging before nap time is over.
Sure enough, walk right in and head right over to the barber’s chair – no wait. The plan is executing perfectly so far. Sports are on the TV, and my barber is content to cut my hair without much chit-chat – good by me. Quick cut, looks good, 95% of the way done, just need to pay. As I pull out my wallet, I catch a glance at the “cash only” sign, and of course, I have no cash.
I’m stuck. No cash, my bank isn’t close by, and I can’t leave my barber with an IOU. There is one solution, this cash-only business has conveniently placed an ATM in their lobby. This ATM will charge me $5 to withdrawal cash in addition to the fee my bank will charge me for using a non-bank ATM. This annoys me, but I really have no other choice.
This is a liquidity crisis – I need cash, and there isn’t an easy or convenient way to obtain cash, and access to cash (the ATM) comes at a cost.
Now, let’s discuss some other intersections of liquidity and your personal finances. These examples will help give us clarity around the practical applications of liquidity.
What’s the typical way one goes about acquiring a home? Often, it’s a 20% down payment, and the other 80% is financed with a traditional mortgage. Imagine if someone had a million dollars and was planning on buying a one-million-dollar house. This individual could pay cash for the home, or they could finance a portion of the home with a mortgage. What benefit does financing the home present? It allows the individual to retain access to their cash and all the benefits associated with having that access – to cover emergency expenses, participate in investment opportunities, etc.
Here’s an important fact to highlight – whether the home was purchased with cash or financed 100% with no down payment, one’s total net worth does not change. By paying cash, the individual would have a million dollars in equity. Financing 100%, the individual would have a million dollars in cash, a million-dollar asset (the home), and a million-dollar liability (the mortgage). Both balance sheets would reflect a one-million-dollar net worth.
The decision to finance a property, the decision to pay down a loan, the decision to make a cash purchase are all liquidity decisions, and they have an impact – often a major impact – on one’s financial plan. Yet, these purchasing/financing decisions are often preference-driven, emotionally fueled, and liquidity or illiquidity is not often considered.
Some of the most financially successful individuals I’ve met are entrepreneurs, business owners. I’ve heard some AMAZING stories, the sorts of rags to riches stories, pull yourself up from your bootstraps, American dream-type stories. These business owners have every reason to (1) believe in their business and (2) invest in their business.
Here’s another reality, many of these business owners have a balance sheet in which their business is a large majority of their net worth. Their business is their largest asset, and their business is an illiquid asset. Illiquid being the opposite of liquid, meaning that this asset is not easily converted to cash.
Is this a potential issue for a business owner? It could be. But often, cash flows are blinding, and there can be an overconfidence that one’s business is unbreakable. 2020 tested a lot of businesses and was eye-opening for many, revealing the fragility of their business.
This is why we hear adages like, “taking some chips off the table.” When you build a successful business, you often concentrate your wealth and create some liquidity. You often need to explore the options behind “cashing out.”
In the world of finance, if an investment is not a stock, bond, or cash, we have a catch–all category we call “alternatives.” These alternatives range from private strategies like private equity, private lending, and private real estate to a gamut of different hedging strategies (e.g., hedge funds).
This catch-all category does not only represent a unique array of investment opportunities, but each strategy also comes with its own unique liquidity profile. There are guidelines and expectations around how someone might redeem their investment for cash. Some strategies might have a 10–year lock-up, while other strategies might allow you to redeem monthly or quarterly. Beyond the importance of understanding these liquidity windows, it’s also important to understand how these rules might change in times of distress. Understanding the gates and protocols that might also limit your ability to redeem an investment is very important.
This liquidity reality can sometimes feel limiting, but it presents its benefits too. Often publicly traded securities are so liquid that they encourage lots of buying and selling, and this buying and selling can often reflect the short-term sentiment of investors. So, you end up having two driving forces moving prices (1) the structural/fundamental realities of the market and economy and (2) the sentiment of the market participants, often defined by extreme fear or euphoria. You can imagine how volatile those emotions can be and the impact they have on security prices. In private markets, you can sometimes be insulated from this sentiment volatility, and sometimes the prices can be more grounded in the fundamental valuations of the actual underlying asset. So, in this case, illiquidity can be viewed more as a feature than a bug.
Awareness is key, though; you don’t ever want to be surprised by illiquidity. Thinking you can redeem, making a plan that depends on redemption of a certain investment, and then finding out you cannot is the making of extreme disappointment and possible financial damage or ruin.
The Beauty of Cash…
Do you know what would have made my Saturday? Cash in my wallet; enough cash to cover my haircut.
Sometimes cash can seem like a nuisance because of the current low-interest rates or even just the burden of making sure you always have it on hand, but I will tell you this, if you find yourself paying $5 at your Barber’s ATM or running late to a sporting event or a concert because you didn’t have cash for parking, you’ll know it’s a nuisance not to have cash.
Your portfolio isn’t so dissimilar; there should be a plan and strategy for how much cash you have on your balance sheet. Some advisors or financial writers might try to convince you to replace your cash allocation with some other strategy or investment, but sometimes cash is king. Sometimes liquidity is key, and cash is as liquid as it comes. Maybe my banker might try to convince me that a debit card is a good proxy for cash or that my credit card is a perfect surrogate, but I’ll tell you this much, my barber doesn’t agree. Cash is cash.
So, where do you go from here?
Well, I suggest you look at your financial plan and portfolio through a new lens, the liquidity lens.
Are there parts of your balance sheet that are illiquid? Could this possibly cause strain on the other parts of your balance sheet during times of market stress? Are there strategies and plans you should be implementing to improve the liquidity of your balance sheet?
All good questions and all great conversations to have with your financial advisor.
So… Off you go…