Liquid assets are an important part of a portfolio because they can be quickly converted into cash
- Liquid assets are assets that are easily and simply converted to cash.
- Examples of liquid assets include cash, bonds, and CDs.
- Assets that lack liquidity require time or effort to trade or sell, like real estate or collectibles.
You've probably heard the term "liquidity" thrown around when it comes to your portfolio and assets. It refers to how quickly an asset can be converted into cash. As such, liquid assets are those that can easily be sold or traded.
Liquidity is really a gauge of how much access an individual or business has to cash. The easier an asset - be it an investment, a collectible, or even a precious metal stored in a safe somewhere - can be "liquefied" for its cash value, the higher its liquidity.
"A liquid asset is something you can pay rent with next month," says Jedidiah Collins, a certified financial planner and financial educator who runs Money Vehicle, a financial literacy program. "It's something I can change into cash fast, to put it more simply."
Each type of asset has a differing level of liquidity. But liquid assets tend to include things like money in bank accounts, certificates of deposit (CDs), and even certain types of bonds such as US Treasuries.
How liquid assets work
For an asset to be considered truly liquid, there are several boxes to tick:
- A liquid asset must exist or be traded in an existing, established market. That means that there are buyers and sellers and the asset is always (or nearly always) in demand at some price. When there's always a buyer, the asset is easy to sell or trade, making it more liquid.
- A liquid asset can be converted to cash quickly. The more difficult or time consuming it is to sell an asset, the less liquid the asset is - otherwise known as illiquid. Collins says an illiquid asset is something that requires at least some leg work to exchange for cash: "An illiquid asset would be anything I need to find a buyer for. Something that there's not a buyer readily available for."
- The process of selling or trading the asset also needs to be both secure and simple for it to be truly liquid. Think about the cash you may have in a bank account, for example. The cash in it is considered a liquid asset because the process of getting it out is as easy as a trip to the ATM. And because banks are liable for the the safely securing your funds, they're also protected. The same goes for other assets like stocks or exchange-traded funds: Stocks can be easily traded or sold for cash since there's always an interested buyer.
Finally, the vast majority of liquid assets also are the type most commonly owned by investors. That is, they're things like stocks, or other easily-sold securities such as US Treasury bonds. Cash, of course, also fits the bill, as it can be used by anyone at any time.
Analyzing liquidity
When considering liquidity for businesses and organizations, analysts can use solvency and liquidity ratios to determine their ability to meet short- and long-term financial obligations. This can help them make investment or spending decisions.
There are numerous ratios that are used. Two of the most common are the quick ratio and the current ratio:
- The quick ratio takes into account a company's most liquid assets, and calculates whether it can meet its short-term (within one year) costs.
- The current ratio also helps determine if a company can handle its short-term costs, but incorporates more variables into the calculation. It's another method for calculating whether the company's current assets exceed its liabilities.
There's a lot more to know about these ratios alone. But remember, they're usually used for businesses and not necessarily calculating personal liquidity.
Liquid assets examples
Assets come in a variety of types, and are spread across a spectrum of liquidity. Even among certain asset types, liquidity can vary - some real estate assets may be more liquid than others, for example.
Here are some of the types of liquid assets:
- Cash, and cash equivalents: It doesn't get much more liquid than cash. It can be used to purchase just about anything, and doesn't require a transaction to "liquify." Cash equivalents, such as CDs, are in the same bucket, although there may be a fee to pay when liquify ing this type of asset.
- US Treasury bills and bonds: Treasuries are bonds issued by the US government. They are among the most liquid types of bonds, as there are always buyers in the market.
- Stocks: As we mentioned before, stocks are liquid in that they can easily and almost always be purchased or sold for cash at a moment's notice. It may take some time for cash to hit your account, of course, and you may take a loss on the sale. But the speed and ease with which stocks can be liquidated is what earns them a spot on the list.
- Bonds: Much like stocks and other securities, bonds can be sold at any time for cash so long as the markets are open.
- Mutual funds: While not quite as liquid as other securities as they only trade at the market close, mutual funds can be liquidated for cash rather fast and easily.
- ETFs: Perhaps best described as baskets of investments - like a bundle of stocks - ETFs trade on exchanges like other securities. Since they trade easily, they are likewise fairly liquid.
- Foreign currency: Foreign currencies are cash, and as such, are highly liquid. You would need to exchange a foreign currency for US dollars, which may require an extra step, but in terms of liquidity, foreign currencies are among the most liquid assets you can own.
- Precious metals: Gold, silver, platinum - precious metals are fairly liquid, as they're easy to sell for cash. It might require a trip to a local coin shop to access the "market," but in terms of liquidity, precious metals tend to tick the boxes.
Quick tip: It may be best to think of liquidity as a spectrum - different assets will have varying levels of liquidity. And within each asset class, certain assets may be more liquid than others. For instance: Certain types of bonds (Treasuries) may be more liquid than other types.
Example of illiquid assets
Conversely, illiquid assets are those that cannot be easily converted to cash. They may take a while to sell, or lack a bustling market full of potential buyers. The point is, it'll be tough to turn these types of assets into fast cash:
- Real estate: Real estate may hold a lot of value, but it is neither fast nor easy to sell. On average, it takes around two months to sell a house in the US, making real estate an illiquid asset.
- Collectibles: Collectibles can be almost anything, from baseball cards to paintings. While these assets may hold value, it can be difficult to find buyers, depending on the specific market, and their values may be hard to assess. For that reason, collectibles are considered illiquid.
- Stock options: Like other items on this list, stock options may be valuable, but aren't easy to transfer or squeeze cash out of.
- Private equity: Do you own a share of a business or organization? This is also called "equity," and while it may be of some value, that value isn't easy to tap into.
- Intangible assets: It's hard to define intangible assets since they're, well, intangible. But they may include things like intellectual property. These would be illiquid, given their specific nature, and a lack of an immediate marketplace where they can be exchanged for cash.
The financial takeaway
Liquid assets give their owners quick and easy access to cash. They can quickly be sold, granting access to their cash value, in contrast to illiquid assets, which may take more time and effort to sell or trade. Generally, you should keep a portion of your overall assets as liquid assets, in case you need to get your hands on some cash.
A good goal? Think about how long you'd be able to maintain your lifestyle, and tackle all of your financial obligations, if you sold your liquid assets - and aim for three years' worth of available cash. "It's not a percentage of your portfolio that matters," says Collins. "It's about the protection of your lifestyle."