What are my liquidity needs?

Here is yet another financial term that sounds more complicated than it really is. Your liquidity needs simply refer to how much readily accessible money you need to cover your regular expenses, upcoming purchases, and/or emergency spending. When your investments are liquid, it means that you have easy, fast access to cash and that your investments aren’t locked up in the value of your house or 401(k), for example.

Understanding your liquidity needs will help you determine the right investment types to implement your portfolio.

How to invest if you have high liquidity needs

Do you have a shorter-term goal? For example, are you in the process of paying off your student loans or saving for a house in the next couple of years? If so, your liquidity needs may be high, which requires having cash on hand to pay these expenses. Cash is the most liquid investment choice, of course, but certain types of stocks, bonds, and exchange-traded funds (ETFs) may also be considered liquid as well, because many are easy to sell quickly.

If you have high liquidity needs, saving and investing using highly liquid investments is the best strategy. It also may make sense to invest more conservatively, which could help avoid a situation where a drop in the market causes you to not have enough cash or, possibly worse, to have to sell investments when the market is down.

How to invest if you have low liquidity needs

If you are focused on retirement many decades away, or if you don't have any near-term large purchases planned, you may have lower liquidity needs and can afford to invest in more illiquid assets. This will help you diversify your portfolio and possibly protect against the performance of the markets in times of economic downturn.

Asset classes like stocks that are publicly traded on large exchange are easy to sell quickly on short notice and may be appropriate for those needing short-term liquidity. Certain account types such as retirement accounts or investments like private equity and hedge funds are less liquid and more suited to investors with low liquidity needs.

Liquidity needs help determine your investment strategy

Your liquidity needs are an important factor in determining the composition of your investment portfolio, especially when markets get choppy. Investing in a manner that allows you to cover your liquidity needs while staying invested for the longer term is ideal, because, historically, the markets have always come back from short-term volatility and rewarded investors who stayed the course.