You might be making 8 per cent a year on your private mortgage pool, but could you get your money back promptly if you needed it? How liquid are your investments, really?
"Liquid," in financial terms, is the ability to cash in or sell an investment quickly at or near the current market price, according to the Financial Consumer Agency of Canada website. Being able to get your money back without losing your shirt is critical.
Yet many investors put yield first – only to regret it later. Liquidity means not only that you can sell an asset, but that you can sell it at a reasonable price.
The liquidity spectrum ranges from cash to stocks and bonds to real estate. The degree of liquidity affects the value of an investment: The longer you're willing to tie your money up, the more you can expect to be compensated.
Take real estate, one of the most popular – yet least liquid – investments around. Real estate investments can increase your return and lower the volatility of your portfolio, says Clay Gillespie, managing director of Rogers Group Financial in Vancouver. "The downside is you may not be able to get out of them when you need to." Even stocks and bonds – and the funds that hold them – can be painful to sell in a falling market.
Before you buy, consider how the investment might fit into your entire holdings, Mr. Gillespie says. If you're saving up for a down payment on a home, for example, you wouldn't want to risk your savings in the stock market. Stocks should be held for the long term.
"Always invest your money based on when you want it back," Mr. Gillespie says. "If you start with that premise, then all these liquidity issues go by the wayside."
Too often, people who can least afford it buy something unsuitable in hopes of making big gains. A widow in her 70s plunks down $100,000 for a share of a condo development that is never built. A couple in their late 60s invest their life savings in high-yielding U.S. second mortgages just before the 2008 financial panic.
Historically, less liquid investments have been the preserve of wealthy individuals and pension funds. The Canada Pension Plan Investment Board can invest in roads and bridges and ports because it has a big enough stash of marketable government bonds to meet pensioners' needs for many years.
"From a liquidity perspective, the percentage of your assets that could be illiquid is dramatically lower for ordinary investors," says David Kaufman, president of Westcourt Capital Corp. A typical retail investor might hold cash, guaranteed investment certificates and some blue-chip stocks and bonds. Of a $100,000 portfolio, no more than 20 per cent should be alternative investments such as real estate, mortgage pools, commodities and gold.
Once you have determined how much you can tie up long term, spread the money around, Mr. Kaufman says. Don't invest in just one thing. "In case the investment doesn't pan out, look for diversification." Think about what could go wrong – like 2008.
"When everyone's running for the exits at the same time, there may be no bid on the asset because at that moment no one wants to buy it," Mr. Kaufman says. This is especially true of riskier investments such as shares of small, early-stage companies, high-yield bond funds and thinly traded ETFs.
It doesn't take a full blown financial panic for liquidity to dry up. A "flash crash," where prices plunge in an instant, or a damning research report, can make it difficult to sell for a reasonable price. When these sudden downdrafts occur, anyone who gets caught offering to sell at the going price – called a market order – stands to lose a bundle.
In the late August stock market drop, halts in trading caused by circuit breakers designed to slow the fall wreaked havoc for even blue-chip ETFs because of difficulty in pricing them. On Aug. 24, the iShares Core S&P 500 ETF fell by 26 per cent in intraday trading, far below the index it tracks. Among the ETF's holdings are blue-chips such as Apple Inc., Microsoft Corp., Exxon Mobil Corp. and Johnson & Johnson Inc..
Over the past year or so, fears have been growing about a possible liquidity crisis in the bond market if and when investors, up to their ears in bond funds and ETFs, all rush to sell at once and buyers are scarce.
"Make sure you're not caught in a crush," Mr. Gillespie says. "Design your portfolio so you have liquidity to cover your needs. You have to ensure you're never forced to sell."
Tips for avoiding a cash squeeze
- Set aside a contingency fund for emergencies. Keep the money in a savings account or cashable GIC.
- If you are retired and living on a fixed income, keep some of your portfolio fairly liquid – in a one- to three-year bond or GIC ladder – so that you’ll have money coming due each year, Mr. Gillespie says. This way, you won’t be forced to sell your stocks or other longer-term holdings in a bear market.
- If you are saving for a holiday, or to buy a home, keep your cash in a daily interest savings account or term deposit so you’re not at the mercy of the markets when you go to withdraw it.
- Curb your appetite for real estate, especially if you have to borrow to buy it.
- When it comes to investing, think twice about doing it yourself. Individual investors are prone to chase returns without fully understanding the risks. You may do better with an adviser or portfolio manager.
- Be wary of long-term bonds because their prices will fall if and when interest rates rise.
- Understand your risk tolerance so you won’t be panicked into selling in a falling market.