When managing money, you should be conscious of your liquidity situation. Liquid asset are often what enables you to take advantage of opportunities. If you have too little liquidity, you will be forced to react to your environment. People who are heavily leveraged or are too exposed to illiquid assets will often get caught in liquidity traps.
For example, people who aggressively buy securities on margin can get a margin call if their assets’ values drop below a maintenance point. In this situation, the broker will automatically start selling securities to cover the minimum margin requirements. This presents a couple significant problems. The first problem is obvious. The individual was fully invested in assets that were dropping in value.
The second problem is much less talked about. When asset prices fall, they can often be bought at bargain prices. If you were leveraged or fully invested, you have no capital to deploy. In addition, the prices of your assets are likely to recover over time, provided you made sound investment choices. If the assets that cause you to get a margin call recover, then you were likely forced to sell at the bottom. By maintaining some liquidity, you could have ridden out the storm and would have been better off financially.
Sure, you can sell other assets assuming they are liquid. Many are not. For example, rental properties can take a long time to sell. So, if you have a great investment opportunity, you may not be able to dispose of a rental property in time to make the deal happen. Sometimes your biggest losses are the opportunities you couldn’t take advantage of.
Non only do you have to be careful on how much leverage you have through borrowing money, but also you should avoid having most of your net worth tied up in a single business, rental property, or other illiquid investment. Rates of return, volatility, and other metrics get discussed more often than liquidity. But, that doesn’t make liquidity less important.
Many start-ups overlook liquidity when managing growth. If they grow too fast, they may be putting themselves at risk. Of course, the devil is in the details. For instance, they may be selling expensive new products and not being fully paid in cash at that moment. Retailers and middlemen often take a month or more to pay. Meanwhile, the new start-up had to purchase raw materials, pay for labor, and cover their fixed costs. Because these costs have to be paid prior to collecting the money from the sale, fast growing companies need to manage their growth carefully.
All of this being said, you should definitely be conscious of how liquidity factors into your business and other financial affairs. You should treat each new investment just like a business. Liquidity is a part of your margin of safety as wells as a mechanism for taking advantage of new opportunities. The less liquidity, the more impact a financial disruption will be.