You may have never thought about the "right amount" of liquidity – or even about liquidity at all! Liquid assets are the things that can be quickly converted to cash at a fair price. So money in a bank account is liquid, as are investments held in non-retirement accounts. Things like your home, car, or retirement accounts, on the other hand, are not considered liquid – if you need to sell on short notice, you may not be able to find a buyer, may need to accept a lower price than you want, or may have to pay a steep fee to access money in retirement accounts.
Liquidity is simply the ratio of your liquid assets to your overall net worth, and maintaining the right amount can give you the confidence to live in the moment. People tend to feel more secure knowing that they have enough liquidity to cover 3, 6, or even 12 months’ worth of expenses – even if that means not optimizing every single dollar. Remember: you take on risk when you invest your money, but you can also take risks without realizing it by holding too little in cash.
Important Questions:
Do you maintain a savings account with at least 6 months’ worth of necessary spending?
Do you have any major purchases planned during the next 6 months that require extra liquidity?
Would more liquidity help smooth out irregular income?
There is no "one size fits all", but answering those questions should give you a pretty good idea if you could benefit from more liquidity.
How much should you keep in a savings account?
The cash side of liquidity is one of the most important cornerstones of your financial health.
Let's get the easy part out of the way – if you have a big purchase coming up this year (home or vehicle downpayment, family vacation, new computer, etc.), then the utility of having a lot of money in cash is obvious. More cash available = less debt required, which is always a good move. We're all on the same page about that, right?
But there is another reason to set aside cash: all the stuff you can't plan. This kind of savings account is called an emergency fund, but money set aside for the unexpected isn't just for when things go wrong; you can also think of this as your "sunny day fund" to take advantage of new opportunities. Here are just a few of the things that you can do with your cash reserves:
Manage emergency expenses like medical bills or home repairs
Treat yourself to a spontaneous weekend vacation
Act on a time-sensitive business opportunity
Ease the stress during a stock market downturn
Take an extended break between jobs to weigh options
Smooth the ups & downs of lumpy income
So how much should you set aside for the unexpected? There are a few important rules of thumb, all of which depend on one critical factor: how much you need to spend each month to maintain your quality of life. If you don't need to spend that much, building up an emergency fund will be easier; if you spend a lot, it will take extra effort. Here are some suggestions:
Plan to set aside a minimum of 3-6 months' worth of expenses. The larger your reserve, the more unexpected events you can manage.
If you and a partner each have stable, secure employment, you can lean closer to the 3 month side.
If either or both you and a partner have unstable or insecure employment (which includes a lot of musicians, artists, and self-employed people), aim for 6 months' or higher.
If one person in a couple earns significantly more than the other, aim for a higher target. That's because a loss of the higher income will have an outsized impact on the ability to manage expenses.
The more lumpy or unstable your income, the more you will benefit from a large cash reserve.
The more nervous you are about money, the more peace of mind you will find by holding a large cash reserve.
Your emergency fund impacts the rest of your financial health, too. A large savings account balance can help you sleep better when the stock market tanks, avoid taking on debt, and manage unexpected tax liabilities.
Cash is liquid, but what else counts?
Liquid assets are those that can be quickly converted to cash at a fair value, so obviously cash is the most liquid of all.
What may not be obvious is that nearly all investments held in non-retirement accounts also count as liquid assets. Virtually every modern brokerage company makes it easy to sell stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs) during any trading day (quickly converted to cash), and – even though the market values of those assets may rise and fall throughout a trading day – investments are sold at the current market price (fair value).
Having the right amount of liquidity helps build financial stability and security, but investing involves different risks than money a bank account. It's important to understand the different pros and cons that cash & investments offer in maintaining enough liquidity.
Cash is reliable, but it also loses value over time as inflation erodes your purchasing power. This is called inflation risk. Therefore, cash is very safe in the short-term, but keeping too much in cash is a risk in the long-term.
Investments involve different kinds of risk, the primary one being volatility (prices changing unpredictably). Stocks and stock funds tend to be very volatile in the short term, while bonds and bond funds tend to be less volatile. Some investments, like money market funds, are considered cash equivalents and should have very, very low volatility.
While stocks are very volatile over short periods of time, but they also tend to consistently perform the best over longer periods of time (5+ years).
Bonds and bond funds tend to be less volatile than stocks – making them safer in the short-term – and tend to perform better than cash but worse than stocks over long periods of time.
You can balance the mix of stocks, bonds, and cash equivalents in your investment accounts to smooth out some volatility while also aiming for growth that outpaces inflation.
Only people with the very, very highest tolerance for investment risk should own only stocks in investment accounts.
The sooner you need your money, the less volatility risk you should take. If you need your money in less than 2 years, keep it in cash. If your time horizon is 2-5 years, a fairly even mix of bonds & stocks is a good fit. And people with longer time horizons (10+ years) before needing to convert investments to cash can own a larger portion of investments in stocks relative to bonds and cash.
Are you currently saving in both retirement and non-retirement investment accounts? While most retirement accounts give you a tax break for saving, they also have strict conditions for when and how you can access that money. In other words, retirement accounts are not liquid. A well-rounded approach to saving & investing should include cash in the bank and both retirement and non-retirement investment accounts.
The positive emotional impact of a good Liquidity score
Perhaps the most powerful part of maintaining a high liquidity score is the the positive emotional impact.
Most creatives & self-employed people take on a tremendous amount of risk when it comes to income stability. Even creative people with relatively stable salaried jobs may decide to choose a more satisfying opportunity over a less satisfying position that pays more.
Improving your liquidity score not only helps improve your financial health; it also makes you more emotionally resilient in the face of uncertainty.
It's stressful to have to move from one gig to the next just to pay the bills, and people don't tend to make rational, deliberate decisions under stress. Extra cash set aside in a savings account turns down the temperature on that stress, helping you make better decisions.
A high liquidity score also gives you the freedom to pursue bigger opportunities. How confident would you feel about taking a big swing at an exciting project if you knew you had the next 3 or 6 or 12 months' worth of expenses already in the bank? A lot of liquidity can give you that confidence.
You might be surprised to hear that lots of available cash also makes you a better investor! The number one superpower available to all investors is compounding growth over long periods of time – but that compounding only happens if you don't interrupt it. A strong amount of liquidity makes it easier to withstand the ups & downs in your investment accounts because you know that you don't need that money right away. That extra buffer gives you a leg up on every panicky investor who decides to sell out of fear.
Finally, a high liquidity score lets you sleep better at night. When you have enough cash in your savings account and the investments in your non-retirement accounts are outpacing inflation, there are simply less moving pieces to worry about. Checking those two off your list removes a lot of extra work & worry from your plate.
Need to review your own liquidity needs? Sign up for Office Hours for an informal chat and honest perspective. Want to take it one step further? Complete your financial scorecard to compare your Liquid Term – the amount of time your liquid assets could support your current spending – to other areas of your financial health like retirement accounts (Qualified Term), property (Real Estate Term), businesses (Business Term), and your Total Term, which represents how many years you could live on just your current net worth.
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
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