As you know, the goal of personal finance and investing is to grow your money over time without taking unnecessary risks. An important aspect of safeguarding yourself without limiting your ability to earn large returns on your investments is diversifying your assets.
While most people think about portfolio diversification in terms of high-risk and low-risk investments, it also has to do with liquidity. You need to strike a balance between liquid investments and illiquid investments in order to maintain a healthy financial picture.
What it is and Why it Matters
The word "liquidity" is one you've certainly heard before, but what is it? Essentially, liquidity refers to the ability you have to convert an asset into cash (and the speed at which you're able to do so).
Think about it in terms of a drink. If you're thirsty and want something to drink, would you reach for the bottle of water that's been sitting in the freezer or the one in the refrigerator? While the one in the freezer has value - it can be used as an ice pack and can eventually be consumed when melted - it's pretty useless at the present moment. You'd have to wait hours to be able to drink it. On the other hand, the water bottle in the refrigerator can be consumed immediately. That's because the water bottle is (quite literally) liquid.
In terms of finance, liquid investments are investments that can be converted into cash without much effort. Illiquid investments take time to convert. In other words, the higher the liquidity, the quicker it can be used.
"While it isn't terrible to have some illiquid assets, it's vital that you have some of your wealth in assets that you can sell quickly if needed," Miranda Marquit writes for US News and World Report. "Some illiquid assets have the potential for long-term gains, but you have to be in a situation where you don't need to sell them; you need to be able to hold onto them until the opportune moment, when they have appreciated in value--and there's someone willing to buy them."
Ranking Investments Based on Liquidity
So, which investments are liquid and - going with our previous example - which ones need time to thaw? Here's a look at some common investments, unofficially ranked in order of liquidity.
1. Precious Metals
You've probably heard people say that gold is one of the safest investments, but why exactly? "It's the fact that the supply is limited," Golden Eagle Coin says. "Advances in technology increased production dramatically at the end of the 19th century, and more modern innovations make it possible to extract gold that wouldn't have been economical before, but there's only a certain amount of it in the Earth's crust and once that's all been mined there isn't any more." The same concept applies to silver.
But it's not just scarcity that makes gold and silver such sound investments. They're also highly liquid. You can go to a pawn shop, a jewelry store, an online marketplace, or even the guy next door, and quickly unload your gold on the spot for cash in hand. If you have gold or silver on you at this very moment, you could sell it in less than an hour - that's the definition of liquid.
2. Stocks and Mutual Funds
Stocks and mutual funds aren't as liquid as precious metals, but they can be converted to cash relatively quickly. Depending on how your stocks are organized and whether you're managing them directly or using a broker, all it takes is a few phone calls or clicks and you can convert your stocks into cash.
The catch is that you typically have to wait for funds to be transferred to your account or a check to be mailed. This means you may not be able to liquidate in minutes or hours. It'll more than likely take a day or two.
3. Real Estate
Real estate, while a wise investment, is considered the least liquid investment around. This is because you can't very well convert real estate into cash in a few hours or days. It most likely takes weeks or months - unless you choose to lower the price significantly and take a major hit. It's still a good idea to have real estate in your portfolio, but just know that it takes time to convert.
Balance is Your Friend
In terms of investing, balance and diversification are hugely important to the overall well-being of your portfolio. If all of your investments are liquid, then you probably aren't taking enough risk. If all of your investments are tied up and take months to liquidate, then you're compromising your present financial situation.
The key is to diversify so you're nimble enough to respond to changing circumstances.