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We have heard so much about liquidity – but why is it important for an investor – as a student I learnt that there are three main reasons for holding cash. Transaction motive, precautionary motive (to meet sudden unexpected expenses) and speculation (stocks/ forex).
Personal Liquidity
Investors should maintain a good part of investible funds as cash. So as to take advantage of any golden opportunities that come along. Of course there is an opportunity cost involved in doing so, but on the upside the big profits that you earn from future investments should cover the opportunity cost. I like to maintain 1/3rd of my portfolio as cash in both bear and bull markets.
Investing the cash in TB until you find the right investment makes sense since then you will get the minimum return required on your money.
Another advantage of this strategy is that you are continuously scanning your portfolio for shares to sell – so as to maintain liquidity. This will allow you to weed out the non-performing stocks and low ROE shares that are reducing your returns. The actual percentage of cash held depends on the personal aggressiveness of individual investor.
Liquid shares
Are those that can be easily disposed of - since there is big demand for these shares and they are regularly being traded. As a rule usually low value shares are more liquid than high value stocks. Shares with a large free float are also more liquid. Why are liquid shares more preferred by some? It allows for quick disposal without loss of value - especially if the investor is in need of quick cash - Useful in forced selling scenarios.
Cash V Debt
Some of us have got more used to borrowing to invest – a system which has been mastered only by a few. The risk here is that you have to factor in the additional interest cost that has to be borne in addition to all the other risks and expenses. Over the long run debt tends to erode portfolio ROE. But don’t be afraid to borrow if you are convinced of a good buy and need only borrow for the short term.
