Portfolio Ideas. Why you should pay attention to liquidity

If you are like most individuals, you would prefer investments that are highly liquid. The only exception, of course, is your real estate investment. Then, how concerned should you be about investment liquidity?

In this article, we discuss why liquidity is important for your equity investments.

Liquidity refers to your ability to easily sell your investments at the last traded price. The importance of investment liquidity can be best understood in the context of a core satellite portfolio. In this framework, your core portfolio is geared towards achieving your life goals such as your retirement expenses and funding your child’s college education. Your satellite portfolio is created to take advantage of short-term fluctuations in the financial markets.

The core portfolio typically contains stocks and bonds. The allocation to stocks is made through systematic investment plans in equity mutual funds. The bond investments are made through recurring bank deposits.

You do not, therefore, need liquidity for your bond investments. Why? Suppose you require lumpsum money at the end of six years and four months, you will create a deposit to match its maturity period with your investment horizon.

What if you need money to meet contingencies? You should not depend on your core portfolio but instead have an emergency fund. This fund should be primarily in specially earmarked savings account and bank fixed deposits. Liquidity is, however, very important for your equity investments. Why? Unlike bond investments, equity investments do not have a finite life.

This means you have to sell your equity investments at the end of your investment horizon and gather the proceeds you need to meet your life goals.

You also need liquidity to moderate the effect of asymmetric returns on equity during your investment horizon. Suppose two years after your initial investment, your portfolio carries unrealised gains of 25 per cent. If you are unable to sell your investments due to lack of liquidity, a 20 per cent decline can wipe out all your unrealised gains. On the other hand, you need 33 per cent upside to recover 25 per cent of unrealised losses.

You should, therefore, protect your unrealised gains in your equity core portfolio. And you can do so only if your equity investments are liquid.

All investments in your satellite portfolio have to be liquid. Why? You should be able to actively buy and sell your investments to take advantage of short-term market fluctuations.

This means your equity investments should be in exchange-traded funds (ETFs) or stocks. Your bond investment should be in tradable bonds such as tax-free bonds. You should also consider gold ETFs. We have not discussed real estate for two reasons. One, you would own a self-occupied house. Though you save on rental expense, it is not an investment asset; an investment has to earn actual returns. And two, even if you do own an investment property, your primary source of return would be rental income.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in