The Importance of Liquidity and Liquid Assets

After the September 11th terrorist attacks, the American financial system was shut down for four days. With stock exchanges closed, investors learnt the importance of liquidity after they temporarily lost access to cash and investments. A year later, as we reflect on the tragedy, investors should remember one important lesson: at least some portion of your net worth should be liquid.

What are liquid assets and how can I store them?

The term liquidity refers to how fast something can be turned into cold, hard cash (the kind you stick in your wallet). Liquid assets are those that are thought to be turned to cash immediately. On one extreme of the scale are the dollar bills and change you have stuffed in a cookie jar or mattress at home. These are the most liquid assets (meaning you can immediately spend them), but the least safe. On the other end of the scale are assets such as real estate, which can take months or even years to convert into cash.

When seeking liquidity, there are several places you can stick your cash. They include:

• Your house (hopefully well hidden)
• A savings or checking account
• A money market account
• Short-term certificates of deposit

In most cases, depositing your money in a bank is considered extremely safe. America's banks have not be frozen since 1933 when Roosevelt declared a "banking holiday" which lasted three days, and it seems relatively unlikely such an event would happen again in the near future. Money market funds can cause problems because, in the event yours is administered by a mutual fund company, you may lose access to your cash if the financial markets shut down (which is precisely what happened to many investors on September 11th).

For emergency purposes, you should not consider stocks, bonds, mutual funds, government treasuries, annuities, or insurance policies as liquid assets. In addition to normal market fluctuations, these investments may become completely illiquid if the exchanges are closed.

Why should I keep liquid assets?

Even if you don't own any investments, you still need a cash reserve. Why? Think back to last year. Once Manhattan was shut down, many businesses could not operate. In some cases, employees were not paid for several weeks, leaving them without a source of income. What if there was a tragedy or extraordinary event in your area and you suddenly couldn't report to work? Taking the scenario one step further, what if such an event caused your company to run into tough financial times and it either closed its doors or started laying off most of the work force? How would you survive? If you had realized the importance of liquidity, you would be able to stay afloat for at least several months using your cash reserves.

What degree of liquidity should I personally maintain?

The level of liquid assets you should keep on hand largely depends upon your estimated monthly expenses. In all cases, you should be able to support yourself and family for at least a month or two; most financial planners agree that six months is ideal. It's important to remember that national emergencies are much less likely than personal emergencies such as car repairs, layoffs, washer and dryers falling apart, etc. Having cash on hand will allow you to stay the course with far fewer worries.