How to strike a balance between liquidity and returns?

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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Liquidity is generally defined as the ease of converting an asset into cash without compromising on its value.

In short, liquidity consists of two parts: Ease of conversion and preservation of value.

When we opt for lower liquidity, we are taking on greater liquidity risk. And we are compensated for this risk with higher returns (generally).

For example, equities. Most people think that equities are liquid but they are not. Equities can be easily converted into cash but may not necessarily preserve value. At the point of liquidation, the value of the asset may not be what we invested. 

If equities are as "liquid" as people think, the liquidity risk involved is low and as such, equities wouldn't be able to offer us such high returns, above bonds or risk-free rate.

This is unlike cash in bonds or banks where the preservation of value is high. In other words such assets entail lower liquidity risk and as such offer lower returns (relative to equities).

Especially in a high interest rate environment, it is important to consider our liquidity needs and allocate our assets accordingly between short, medium and long term liquidity needs. Prioritising our liquidity prudently will allow us to maximise our returns while also ensuring capital preservation of our assets during the times when we need to liquidate them.

By taking on some liquidity risk, we can lock in higher yields now for the longer term. A common example would be long term government bonds or the US 10-Year Treasury. While we can simply sell off the bonds before maturity, we may experience some capital loss. For such assets, the primary risk we take on is liquidity risk—the longer the bond duration is, the higher the liquidity risk involved.

Liquidity risk is only one component of the total risk investors take when investing. When investing in equities, it is important to keep in mind that the liquidity risk we take on is high and not low as many think just because we are able to readily liquidate our equities position into cash. Ensuring the preservation of value is a key aspect of liquidity.

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Disclaimer:
The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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