The importance of cash and liquidity
One of the foundational pieces of a solid financial plan is liquidity. Liquidity can mean different things, but today I am talking about cash held in an account that is accessible without incurring penalties or taxes.
For most people, the best place for cash is in a savings account or a money market account. If you are younger than 59 ½, it is generally not possible to access cash in a 401k, IRA, or Roth IRA without incurring penalties. You should also consider early withdrawal penalties before putting money into a Certificate of Deposit (CD).
What is so great about liquidity? I can think of three things, in order of life stage: Safety, Opportunity, and Stability.
Safety
The biggest value of liquidity is the safety it provides. You are probably aware of the standard advice to have an “emergency fund” of cash equal to x months of your living expenses. And that advice is standard for a good reason: it works! No matter how stable you feel your living situation is, you are just one thunderstorm away from a damaged roof (and have you checked your homeowner’s insurance deductible lately?)
Depending on what industry you work in, your job may not be as secure as you think, so it’s important to consider that as well. Even if you don’t ever use your emergency fund – and I pray you don’t – there is something to be said about the peace of mind that you have just knowing that cushion of money is available for you.
Opportunity
The emergency fund is a great foundation for your financial health, but that is not the ultimate value of liquidity. Liquidity can also give you the opportunity to pursue different ventures in your life. Are you currently in a job that pays well, but isn’t the thing you are most passionate about? Having adequate liquidity gives you the ability to go back to school or to take a lower-paying, entry-level job in a field in which you are more passionate.
Even if you love your job and can’t imagine working anywhere else, there may be an opportunity for you to invest your money into something you care about. I’ve talked to someone who used his liquidity to invest in a sustainable farming project in his community. Because this person had surplus liquidity, he was able to divert some of that money into the illiquid farming project.
Stability
When you are retired and no longer earning a paycheck, you will likely be living on the money you’ve saved in your investment accounts. And if you’ve been working long enough to amass a decent savings, you surely know how the value of your investments can fluctuate wildly. And if you rely on that money to buy your groceries, you may be a little nervous! Enter liquidity.
When you have many months’ worth of expenses saved in cash – liquid, stable, cash – you may not need to sell out of your investments when the stock market goes funny. As my partner Christian often says: “rollercoasters aren’t dangerous unless you get off in the middle of the ride”. When we work with retired (or nearly-retired) clients who are living off of their investments (or will be soon), evaluating the cash buffer is one of the most important parts of our process.
Conclusion
Liquidity is a foundational piece of a solid financial plan. Depending on what stage of life you are in, liquidity can serve different purposes.
You may have noticed I didn’t use any numbers in this post, and that is intentional. Personal finance is personal, and the amount of liquidity you need depends on your specific circumstances. If you have a question about your situation, please click this link to contact us.
