The pros and cons of liquidity

Liquidity is the ability to quickly turn your assets into cash. So what are the pros and cons of holding liquid investments?

"The more liquid an investment is, the faster it can be turned into cash without penalty or transaction costs," said Greg McBride, chief financial analyst at Bankrate.

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On the contrary, fewer liquid investments tend to offer the prospect of higher rates of return, such as a certificate of deposit compared to a savings account, he said.

"Liquidity provides peace of mind knowing that you can cover unplanned expenses without having to take on high-cost debt or be a forced seller of assets," McBride said. "The trade-off is that, in exchange for safety and liquidity, this money will earn a lower rate of return that over time will trail inflation and result in a loss of buying power."

For example, a CD pays a higher rate of return, but McBride cautions it can be subject to an early withdrawal penalty that could negate whatever additional return was being earned compared to the savings account, where money could be withdrawn at a moment’s notice without penalty.

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What are some investments that offer liquidity?

According to McBride, the best liquidity is in federally insured bank accounts such as a checking account or savings account where the money can be withdrawn immediately. Money market mutual funds offer liquidity through the ability to transfer to another account, buy another investment or write a check from the account to cover a large expense, he said. 

There may be age parameters to understand as well. 

For example, McBride explained that if you’re under age 59 1/2, your retirement account isn’t very liquid even if it holds liquid investments because most withdrawals would be subject to potential taxes and a 10% early withdrawal penalty.

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Why is it particularly important at this point in time to have access to liquid assets? 

The top two reasons for liquidity are having assets to pay your bills and an emergency fund for unforeseen and sudden expenses. McBride also recommended having access to some assets to take advantage of sudden investment opportunities.

"With such low interest rates, investors often think of liquid money as ‘dead money’ because of the low rates of return, but the rate of return should be measured in terms of buffering you from selling other assets, incurring high-cost debt and having sleepless nights when unplanned expenses arise," he said.

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So in a nutshell, here is McBride's take on the pros and cons of liquidity:

Pros

• Peace of mind knowing that you can cover unplanned expenses
• No need to take on high-cost debt
• No need for the forced sale of assets in order to raise cash

Cons

• Lower rates of return
• Loss of buying power over longer periods of time as returns trail inflation