This is my first ever haiku (and maybe my last), so bear with me:
Cash when you need it.
Doesn’t matter, then it does.
When Berkshire Hathaway reported their earnings earlier this month, the most noteworthy item was their $128 billion cash stockpile. With that amount of cash, Warren Buffett could buy any company in the S&P 500 except for the 40 largest. What’s interesting is that Mr. Buffett hasn’t made a large acquisition in four years. So why on earth would he have that much cash sitting around earning paltry rates of return? He would tell you, “That’s liquidity.”
Buffett is the stock market’s version of a firefighter; he’s made a career of running toward the calamities when everyone else is running away. He did so a decade ago during the Financial Crisis, with some savvy investments in Goldman Sachs and Bank of America. And he wouldn’t have been able to do so without liquidity.
Think about the assets you own. You probably have a checking account, a savings account, a 401(k) or IRA, a house, and possibly an after-tax investment account. You might also own a business, real estate, private equity, hedge funds, or an annuity. How easy would it be to turn each of these assets into cash, and what would be the impact on the price of the asset in doing so? The answers to these two questions determine an asset’s level of liquidity.
Assets that can be turned into cash quickly with minimal or no impact on the price of the asset are considered highly liquid. Cash, savings accounts, and money market funds fall into this category. Many (but not all) individual stocks, bonds, mutual funds, and ETFs do as well.
At the other end of the spectrum are illiquid assets. Private equity and hedge fund investments typically have lockup periods that require you to keep your money invested for a number of years. Annuities have surrender periods that penalize you for taking out your money before a 7-10 year period passes. Selling a business or piece of real estate can take months or even years to get the price you want.
Having too much of your net worth in illiquid assets can come back to bite you at the most inopportune time. We counsel our clients to have an emergency fund, typically 3-6 months of living expenses set aside. And if you have any upcoming major expenses, you might consider holding cash to cover those as well. Beyond owning a home or a business, we’re big fans of having the vast majority of your investable assets in liquid investments. Only after this does it make sense to delve into illiquid waters if you’re so inclined.
The bottom line is that liquidity gives you options, while illiquidity does not. In order to rush into the fire (or at least withstand the fire), you need to have liquidity.
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