How Much Liquidity Is Helpful and When It Starts Holding You Back

Having access to cash on short notice can be critical for high-net-worth households. Besides facing unexpected expenses, you also need cash for a wide variety of obligations. Tax payments, business expenses, rental property maintenance, and capital calls all require that you have cash readily available.

But if a large portion of your wealth is tied up in illiquid assets like a business or real estate, liquidity might be a challenge. Keeping a large amount of cash on hand isn’t ideal, so is there a planning tool that can provide you with liquidity while also helping to meet your long-term goals?

The Cost of Cash

Liquidity refers to cash but also to assets that are easy to convert to cash. Highly liquid assets include most stocks, bonds, mutual funds, and exchange-traded funds. Assets with low liquidity include real estate, ownership in private companies, private equity, venture capital, restricted stock, and certain alternative investments.

Liquidity is necessary because it enables you to absorb unexpected financial shocks and take advantage of unanticipated opportunities. Ultimately, this reduces the likelihood of needing to sell assets at an unfavorable time, which may help protect your long-term plan.

It’s important to distinguish safety from liquidity. While cash is generally stable in nominal terms over short periods, marketable securities like stocks, bonds, and vehicles such as mutual funds and ETFs are less so. Unlike cash, they may decline in value, transactions may settle only after a delay, and asset sales may trigger taxes. Though these assets are highly liquid, they are not as stable, tax-neutral, or immediately available as cash.

To meet your need for liquidity, you could hold large amounts of cash. But that comes with some drawbacks. Over the longer term, cash can lose value due to inflation, and since it won’t be invested in assets with higher expected returns, it can be a drag on your investment performance.

The goal is not to hold as much cash as possible. It is to build a deliberate liquidity plan that gives you access when needed while keeping the rest of your wealth working toward longer-term goals.

How Much Liquidity Do You Need?

Your liquidity needs depend on a range of factors, including income stability, tax liabilities, debt payments, business obligations, capital calls, and how illiquid your current balance sheet is. Also, those who are retired often have different liquidity challenges than those who are employed or own a business. So, talk with your advisor about how much liquidity is appropriate for you.

Once you’ve determined this, you’ll need to set up your liquidity management system. The system should consist of three tiers, with each one corresponding to a timeframe. Near-term needs are those occurring in the next 12 months, while intermediate-term needs generally fall beyond the next 12 months but within the next several years. Long-term expenses are those you don’t expect for many years, such as retirement or education spending. ⁽¹⁾

For near-term expenses, cash is often the most appropriate starting point because it is generally stable in nominal terms and available when needed.

A common starting point is to keep roughly three months of typical expenses in readily available cash and then adjust from there based on income stability, business obligations, and other expected cash demands. Extra cash may also be needed if your near-term expenses include business-related needs or if you own a portfolio of rental properties. ⁽²⁾

A larger cash balance may also be prudent if you’re retired. This may reduce the likelihood of needing to sell assets at an unfavorable time, potentially at a loss or with an unwanted tax consequence. ⁽¹⁾

Intermediate-term expenses aren’t likely for a few years, but you still need to take a conservative approach. For expenses expected in less than two years, cash and short-term investments are still a good idea. For expenses expected a few more years out, a modest amount of investment risk may be appropriate, depending on the timing, flexibility, and importance of the need.

For high-net-worth households, intermediate-term needs might include unexpected investment opportunities or unanticipated cash calls from illiquid investments in alternative assets, such as private equity, private credit, or real estate.

Traditionally, investors in these less liquid vehicles have kept a portion of their allocation to these investments in cash, but this may act as a drag on the higher expected returns. ⁽³⁾ If a large portion of your net worth is tied up in illiquid investments that might involve a capital call, consider discussing how best to address this with your advisor.

The third tier is for long-term needs. Here, growth-oriented assets are appropriate as is some inflation protection. Rebalancing this portfolio is also important; it allows you to realize gains and use the proceeds to replenish the other two tiers, as necessary. ⁽⁴⁾

Whether you are retired, still employed, or a business owner, consider your own peace of mind as well. For some households, a slightly larger cash buffer may be reasonable if the tradeoff is intentional and understood.

The Bottom Line

Consider meeting with your advisor to discuss whether your liquidity is adequate. Here are three questions you may want to discuss: What are your cash needs over the next 12 months? What obligations could appear with little notice? What would we sell first in a downturn, and what would the tax impact be?

Managing your liquidity means more than keeping a lot of resources in cash. By setting up a liquidity management system, you’ll be better able to meet your liquidity needs without compromising your long-term goals.

Sources:

⁽¹⁾ https://corporate.vanguard.com/content/dam/corp/research/pdf/practical_guide_to_managing_your_cash.pdf

⁽²⁾ https://www.ubs.com/us/en/wealth-management/our-solutions/planning/wealth-planning/articles/unique-liquidity-strategies-solutions-high-net-worth.html

⁽³⁾ https://www.pimco.com/us/en/insights/cash-for-calls-managing-liquidity-for-illiquid-investments

⁽⁴⁾ https://www.capitalgroup.com/advisor/practicelab/articles/bucket-strategy-retirement-income.html

This information is meant for educational purposes and not as direct tax or legal advice. Rules and regulations can shift anytime, so it’s always best to consult a qualified tax advisor, CPA, or attorney for guidance tailored to your specific situation.