Welcome to Chemistry class – Financial Chemistry, that is!
If you took chemistry, you might remember the states of matter: solids, liquids, and gases. We can also add plasma to this group as well. Also, remember that there are different elements in chemistry, as referenced by the periodic table. You know, elements like oxygen, hydrogen, carbon, nitrogen, etc. Gold and silver are elements too!
Well, transitioning chemistry to personal finance, we can see that there are many elements of finance that appear in different “states”. Let’s take two of those states, liquids and solids, and apply them to personal finance-oriented assets.
There are some assets that we can consider “liquid”. These can easily go from place to place, changing ownership with little problem. The best way to describe these are that they’re assets that can be sold, fairly quickly, for value that’s close to what they’re worth.
Here are assets that can be described as liquid, along with my assessment of their relative level of liquidity:
- Cash (very high)
- Bank accounts (high)
- Stocks – taxable accounts (medium)
- Bonds – taxable accounts (medium)
- Mutual funds – taxable accounts (medium)
- Stocks – retirement accounts (low)
- Bonds – retirement accounts (low)
- Mutual funds – retirement accounts (low)
- CDs (low)
- Vehicles (low)
Solid (Illiquid) Assets
These are assets that are not easy to sell immediately for what they’re worth.
- Real estate
- Household items (clothes, appliances, etc)
What are the Implications?
You might all of a sudden need money, due to job loss, major illness, accident, or other reason. In times like this, you need to be able to have access to funds immediately to pay your bills. This is why we set up an emergency fund, which should contain the most liquid of assets in order to ensure accessibility of transferable funds. As those of you who read my blog know, I’m a fan of people saving 9 to 12 months for an emergency fund.
Beyond that, it makes sense to have funds accessible, doesn’t it? There could be any number of reasons that you might need or want to spend money or reallocate your overall investment portfolio, and if assets aren’t liquid, that becomes tough.
We have seen this with residential real estate in recent years. A lot of people put forth a significant amount of money into their homes, and have seen the values drop. More relevant to liquidity, however, is that they have been unable to sell their homes at a price that works for them. It seemed like many folks viewed homes as items that could be flipped or sold somewhat easily – thus considering them to be liquid assets. Well, clearly that’s not so, and this makes the case for being able to distinguish between assets that are truly liquid and illiquid. It can affect your finances and your day to day life!
As for collectibles, they’re only worth what someone will pay for them. An old baseball card, or antique figurine, that we might personally value may only be traded by a small group of people out there. Sometimes, the value is more to us individually than to others. With household items, such as clothes, they depreciate dramatically once we bring them home and wear them. Wouldn’t you pay a good deal less for an item of clothing that’s been worn than one that’s brand new? Of course!
My Question for You:
Do you ever think in terms of liquidity when it comes to your portfolio of assets?