You can have all the paper wealth in the world, but if you can't easily convert your wealth into cash to pay your bills, you could be forced into bankruptcy. Liquidity risk is the risk that you will have a difficult time finding willing cash buyers for your assets at anywhere near market price. This could result in an inability to meet your obligations, or a failure to provide capital to keep a business running.
1. Keep your expenses and debt levels low - this is an often overlooked factor. The lower your regular nondiscretionary expenses are, such as debt, rent or mortgage payments, the more choices you will have when building an investment portfolio. It also means you have less to worry about concerning liquidity risk. This may allow you to seek less liquid investments that generate higher long-term returns.
2. Invest part of your portfolio for income. This income can come from rental payments, dividends or interest payments on bonds and debentures. Whatever the source of the cash income, structuring part of your portfolio to generate income can help you align your assets with your liabilities. This can help give you a steady stream of liquidity with which you can meet your obligations.
3. Keep a reserve in cash and cash equivalents. These are low-risk savings vehicles that you can convert to cash immediately, or within just a few days. Examples include cash itself, savings accounts, demand deposit, or checking accounts, the cash value in life insurance policies, and money markets. You can also include certificates of deposits, although these generally involve a penalty of six months interest for early withdrawal.
4. Keep a second tier of liquidity as a back up. For example, short-term treasury bonds and even longer term treasury bonds usually have a ready market in case you want to sell quickly. These may generate higher returns, in the long run, than cash and cash equivalents. When you need to spend cash, consider moving some of that second tier of liquidity into cash and cash equivalents to replace it.
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