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How do I know if I'm investing too much? Here's how you find a balance between having savings in cash and investing. Image Credit: Seyyed Llata | Senior Designer, Gulf News

Dubai: Let’s say you are able to stringently set aside and invest over 50 per cent of your income. Is that too much? How much should be saved up in cash and what portion of that should be invested?

There is a downside to investing so much such that you won’t be able to free up cash when an emergency expense comes up. Here’s why and how you factor in liquidity when investing.

Particularly in today’s environment, investors are seeking new ways to meet their goals. So knowing what liquidity is and how it can impact portfolio returns may help investors make more informed decisions.

Why does investment liquidity matter?

The term liquidity in finance refers to the time and the cost it takes to convert an investment into cash. Many times investors – both newbies and those experienced – focus only on the long-term objective of securing their retirement, not taking into account the possibilities of the unprecedented events.

What investments are considered liquid assets?
Liquid assets include things like cash, money market instruments (like bank accounts, deposits, certain mutual funds), and marketable securities such as stocks and bonds. These can easily be converted into cash in a short amount of time.

On the other hand, illiquidity occurs when a security or other asset that cannot easily and quickly be sold or exchanged for cash without a substantial loss in value. Some examples include selling assets like land and real estate investments, equipment, art, vehicles, jewellery and collectibles.

It is essential to give some consideration to liquidity and not have all your capital tied up as you may encounter the need for urgent cash anytime. In simple terms, liquidity is the accessibility to your investment.

This takes into account how much time it would take for you to access your investment when you are in need. The process of such a conversion differs from asset to asset. In the case of your retirement fund, you will not be able to liquidate funds without the necessary paperwork that may be time-consuming.

On the other hand, your funds in the money market (bank accounts, deposits, certain mutual funds) is very liquid and can be accessed through a linked chequebook or can be easily transferred to your designated bank account.

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Is it easy to access your savings, investments?

Is it easy to access your savings, investments?

Thus, liquidity is the degree to which a security can be, easily and quickly, bought or sold without having its price affected. Your liquidity is determined by how fast your investment can be converted into cash.

For example, you may have money invested in stocks, and you are suddenly in need of cash. You have the option of selling your stocks quickly for a fee, through a broker, and get liquid cash.

Similarly, if you consider a less liquid investment like that of real estate, it is not so easy to convert the sale. This is accompanied by the legal paperwork, the market valuation of the property, seeking out potential buyers, and so on.

Put money in liquid and illiquid investments

Regardless of how much you invest in illiquid assets, you need to have a small portion of your money kept aside to access instantly. This helps to keep the value of your funds intact rather than shifting the value due to any conversions.

The cash you have must be used in times of emergencies only, and it must be restocked right away. There is often a debate about how much is the right amount for such provisions, but it is a personal parameter that differs across individuals based on their needs.

A rough estimate would suggest having at least three months’ worth of your take-home salary in cash or near cash reserve.

How much of my investments should be liquid?

It is advised to have at least 60 per cent of your invested assets in liquid assets such as stocks, bonds, mutual funds and other alternative investment funds. These are funds that you can encash monthly.

In case of a publicly-traded investment option, you will have to ensure to invest with a long-term horizon in mind to avoid any impact on the price.

Another vital point to keep in mind pertains to private investments, where a certain fraction of the investment is under options of easy redemption.

Gauging liquidity of emergency funds, real estate, stocks and equity mutual fund
If you invest in emergency funds, you will have high liquidity, but the returns would be low, as will be the risk. Real estate investment comes with low risk and a higher return, but the liquidity aspect is compromised.

Opting for stocks and equity mutual fund, in the long run, garners higher returns with liquidity, but this is accompanied by higher risks as well. But despite these scenarios, it is a significant component in portfolio investment.
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Having liquid funds significantly reduces the time-lapse from the moment you put the asset for sale to the time you find a buyer.

Liquidity is an overlooked attribute

Having liquid funds significantly reduces the time-lapse from the moment you put the asset for sale to the time you find a buyer. Stocks are a good example of liquid assets which can be traded on the stock exchange on any working day.

It is easier to find a buyer for a liquid asset than for an illiquid one. This does not mean that one must not have illiquid funds at all, but rather, one must not depend on illiquid funds for emergency situations.

The value of liquidity in the investment realm is still underrated. In the race to secure the future, many investors miss out on making provisions for the unforeseen events that can come uninvited anytime.

Not having this security can force you to dig into your long-term investment plans, defeating their very purpose.

Liquid assets maintain their value

To a huge extent, liquid funds manage to retain their value when they exchange hands, unlike many illiquid funds.

When you break into your long-term investments to meet your emergency needs, chances are you’ll undergo a fine.

When you sell your real estate or property, you may or may not get the price depending on the market conditions. But when you break you access your savings account, there is no such loss of value of your funds.

Key takeaways

When planning your investments, it is imperative to factor liquidity in your plans to ensure that you have secured both long-term and short-term needs. This will ensure that you are not going to touch your long-term investments.

When you are investing in various asset classes, ensure you are equipped with ample liquid funds to avail in times of need.

A portfolio of all-liquid investments may not help them reach their long-term goals. So, combining liquid and less-liquid investments may help investors meet the certain objectives.

Investors typically demand a higher rate of return in exchange for giving up liquidity. This is what is known as ‘illiquidity premium’, and it is often a key factor for those investing in less-liquid and illiquid investments.

Finding low-correlated assets, meaning assets that do not move in relation to one another, is key to building diversified portfolios. Less-liquid and illiquid investments have historically exhibited lower correlation to traditional investments.

Investment firms have long turned to less-liquid and illiquid investments to help smooth the returns of their portfolios to drive long-term performance by reducing the impact of volatility on the portfolio.