Early in 2018 while on vacation we nearly out of money. By money, in this case, I mean cash. This wouldn’t have been such a big deal except we were in Honduras. Essentially none of the shops took credit cards. It was a great reminder of the importance of liquidity.
A Liquidity Event in Honduras
I did not mention this on my post about the Cruise way back in May. Honestly, as an experienced traveler, I was a bit embarrassed. I know better as I had this same experience in Europe nearly 20 years ago. That being said I was lured into a bit of security. These days nearly anywhere you go accepts cards. In Iceland, even the bathrooms accepted cards. Cashless transactions seem to be everywhere, except I guess in some less financially well off nations.
Liquidity Is a Priority
In this particular case I was not cashless, but I under calculated my needs for taking off the boat. We had to limit our purchases of Cervesa on the beach in order to afford the taxi back to the boat. No harm no foul. But it was a great reminder, liquidity is something you should keep in mind no matter how high your net worth.
My liquidity event was relatively minor. Compared to some of the large banks where liquidity precipitated their collapse during the great recession, one more beer was minor. Yes, that’s right. Bear Sterns and others were not brought down so much by the amount of debt they held, but rather their lack of liquidity. This week I have been reading about their collapse in the book “Too Big to Fail“. On an aside, another good book I can highly recommend. But I digress…
So what is liquidity? At its essence it is the ability to have cash on hand, or assets that can be easily converted to cash, to handle short term costs. If you can’t pay your short term debts it does not matter how many assets you have, you will end up in default to your debtors. At moderate levels that can mean massive fees and interest, say from not being able to pay your credit card bills. At slightly higher levels it can mean liquidating medium and long term assets at firesale prices. Finally, at extreme levels that can mean bankruptcy court.
Short Term Surprise Costs are Ever Present
Liquidity Needs Beyond An Emergency Fund
But liquidity needs don’t begin and end with an emergency fund. Not all short term cash needs are defined by a surprise short term cost. Sometimes they are known. Even though I underestimated, I knew I needed cash on my trip to Honduras. It was a foreseeable need for cash. The same thing happens in our everyday lives.
Know Costs and Liquidity
If you are saving for a down payment on a house, a purchase of a car, a college tuition payment, or even in our case a travel trailer, then it is best to have at least some cash on hand towards that purchase. So how do you manage that and invest money too?
Stock Market Liquidity
The most common investment are stocks, but that is also the most volatile and sometimes the least liquid. You don’t want your savings cut in half by a stock market downturn when you need it. That volatility makes stocks a poor parking place for liquid money, especially those needed soon. On the other extreme is a savings account. An online savings account can provide a decent return for really short periods but it still might not be the best option. Especially for longer-term planned purchases (say a few years) an online savings account might not provide enough return.
The Best Option for Liquidity Depends on Timing
My comment on savings accounts really hints at the best option for investing for a short term need. The best option depends on the time period until you need the money. I sometimes refer to this as liability matching. Essentially the best way to park money you absolutely need for a short term expense is to invest it in an instrument of the same period as your expense.
So say you are investing beside a mortgage or car payment. You know they will have payments over a defined period and have decided to invest instead of paying more towards your debt. If you found a risk free investment like a bond or CD which comes due in the same period as the debt you have effectively liability matched. Then your return in excess of paying the debt is the difference in interest between your bond/CD and the mortgage rate.
Future Payment Matching
In the same way, if you are saving for a future purchase rather then matching to a debt you can match the timeline. The only difference is you have no debt payment to execute against so your return is simply your total return. The return is risk-free as long as you stick to Government bonds and FDIC insured CDs. If you want a little more risk you can shift to Municipals or AAA corporate bonds. I would not recommend going any riskier with money you need for a near term purchase.
Saving for Our Own Upcoming Purchases
For our future travel trailer
Have you ever used liability matched investing to save for a future expenditure or debt payment?
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