How much of a liquid balance should investment portfolios contain? That question crops up frequently in financial planning as investors try to determine their overall portfolio.
The first part of the question, of course, is: “What is liquidity?”
Liquidity refers to the time required—and the cost incurred—to convert assets into cash. The more quickly and inexpensively conversion can be made, the more liquid assets are said to be. Part of the controversy over liquid reserves stems from confusion between the concepts of liquidity and marketability. A marketable asset is one that can be quickly converted to cash. Bonds, for example, are highly marketable: One simply calls one’s broker and places a sell order. Bonds, however, are not necessarily liquid, and selling at the market price may entail a significant capital loss.
The second part of the question, concerning how much liquidity, isn’t quite as simple to answer. Articles in the popular press suggest that the proper liquid balance would contain reserves sufficient to meet all living expenses for periods varying from three months to a year. But these rule-of-thumb recommendations suffer from a common weakness: They ignore individual economic circumstances and specific motives for liquidity.
Appropriate reserves depend on the probable need for cash, the availability and cost of borrowed funds and on an individual’s propensity to take chances—that is, his attitude toward risk. All these factors vary from person to person, as does the consequent need for liquidity.
One approach to determining an appropriate liquid balance comes from the late John Maynard Keynes, whose suggestion appeared almost as an aside to a work of monumental scope in his book “The General Theory of Employment, Interest and Money.” He observed that individual motives for incurring liquidity costs, by forgoing the opportunity to capture earnings available on assets that are less liquid, can be divided into three categories, each of which requires separate analysis.
A Sacrifice to Convenience
A certain amount of liquid reserves is required simply to facilitate everyday economic transactions. Opportunities to generate higher returns are sacrificed for the convenience of cash and checking account balances. The amount held in this fashion depends primarily upon the dollar volume of the transactions that are undertaken for each time period. This amount also depends on the pattern of cash receipts—the more regular the receipts, the smaller the required transactions balances will be—and on access to convenient credit at reasonable cost. Credit cards, for instance, reduce the need for transactions balances. And overdraft protection in checking accounts are provisions that automatically convert overdrafts to consumer loans and accomplish the same objective.
Precautions for the Unexpected
People also hold assets in a relatively liquid form to cushion against the unanticipated need for cash. For instance, if cash were needed and all assets were tied up in the stock market, one might experience a substantial loss by having to liquidate part of the portfolio during a market downturn. Likewise, the need to liquidate bank certificates of deposit before maturity can prove costly. Some liquid balance above transactions requirements should be maintained as a cushion against the “unexpected,” to prevent these kinds of losses.
The need for precautionary balances depends in part on the certainty of anticipated future cash flows. Someone whose job is contractually secure, and who is assured of substantial advanced notice before his employment contract lapses, will require less liquidity than one whose day-to-day income is highly uncertain. For instance, a tenured university professor or a corporate officer with a “golden parachute” will likely require little in the way of precautionary balances. In contrast, a commission salesman or an independent businessman with an uncertain income stream may want substantial balances.
Access to reasonably priced credit also inﬂuences the need for precautionary balances. Moreover, for a given degree of certainty concerning anticipated future cash flows and with specified access to credit, the desire to maintain precautionary balances will differ according to individual attitudes toward risk.
These balances should be viewed as a type of insurance. The opportunity cost of the balances in the form of forgone earnings is the cost of the insurance policy. Some people will want much more insurance against running short of funds. Others will bear the risk associated with maintaining very low precautionary balances, with full knowledge of the cost they will incur if caught short of liquid assets due to an unanticipated turn of events.
A Speculator’s Balance
Investors who hope to profit from “outsmarting” the market will require liquid balances to exploit their superior judgment about the market’s future course. Their liquidity needs will vary widely, depending upon current market trends. Some conditions will call for an extremely liquid position; others will call for a fully invested position in relatively illiquid assets.
Other investors have no expectation of speculative gains and will pursue a systematic investment program specifically designed to eliminate the impact of market timing. These individuals have little need for speculative balances. Their liquidity requirements are limited to transaction balances and precautionary balances. Investors in this category who have secure employment or whose business or professional activities generate predictable income streams will have a low need for liquid reserves. Their portfolios will be heavily weighted with illiquid assets that generate a higher expected yield than would be possible if they were in a more liquid position.
The Hard Decisions
Liquidity needs obviously vary tremendously between individuals and even for one individual over time. Analyzing the different reasons for liquidity needs helps clarify the problem and focuses attention on the crucial issues.
But as usual, the hard decision-making burden is placed where it ought to be—on the individual who will bear the consequences of the decision.
This article was written by Gaylon Greer for the May 1984 issue of the AAII Journal. At the time, Greer was a professor of finance at DePaul University, Chicago.