In today’s world, financial struggles are commonplace. As many as 20% of middle-class Americans actually spend more than they earn each year. 7 in 10 adults encounter challenges in at least one aspect of money management. Learning the ropes of keeping a household budget and sticking to it has become almost a rite of passage.
And that data comes from just months before the pandemic struck. Times have only become more uncertain since then. We never know where the next disruption could come from, how long or how severe its effects might be.
It’s true that once you start managing your money wisely, any excess cash you can set aside should go into some form of investment. That’s how you can start building wealth. But amid an age of turbulence, we’re constantly reminded of the need to stay liquid. How do you find a balance between the two?
Liquidity is essential
We need liquidity to cover unplanned expenses and shortages. If a family member falls ill or gets involved in an accident, you have to pay for added medical costs. If the primary income earner in the household gets laid off, bills still need to get paid.\How much liquidity do you need? A common rule of thumb is to set aside three to six months’ worth of expenses. For offsetting job loss, you may want to consider instead the average duration of unemployment, which has hovered between two to seven months in recent years.
There are mitigating factors to be certain. Some people may be more employable than others. Insurance may cover medical expenses to an extent. And we can all cut costs during lean times, especially in discretionary spending.
Unequal liquidity
In business, entrepreneurs are well-advised to have an exit strategy. Even a passionate owner of an audiology practice may lose their appetite for the day-to-day management and seek to hand over the keys to a company like HH Acquisitions. No matter what happens, you’ve got a plan in case the forecast turns uncertain.
The numbers may not be as high when personal finances are involved, but the stakes are just as important. Not all personal assets can be liquidated easily. Selling shares in private equity or closed-end funds will prove difficult. There are fewer prospective buyers, and any interested parties will find it tougher to come up with a fair valuation of your assets.
Even more liquid assets, such as publicly-traded shares of stock, may prove to be less than ideal for this purpose. Stock prices fluctuate, and if you’re forced to pull out during a company downturn, you may take a heavy loss. On the other hand, putting money in a savings account is all but guaranteed to depreciate its value over time due to the rate of inflation.
A hierarchy of liquidity
Diversifying is a golden rule among investors. If you spread your money across various asset classes, you minimize the risk of loss due to disruptive events.
However, few individuals think of diversifying their investments according to liquidity. If you sink many excess funds into an IRA, you’re covering the long term nicely, but that money is also inaccessible.
Keep a small amount of money in a checking or savings account. It can be used to pay small emergencies on short notice, and the depreciation over time won’t sting.
You can use something like the Pareto principle to distribute your excess wealth across assets of varying liquidity. Stocks, HSAs, and Roth IRAs all offer better ROI while being more liquid than traditional IRAs or private equity.
Maintain this hierarchy of diverse and liquid assets, and you can be not only resilient to financial shock but flexible as well.
