Liquidity is no doubt important for your portfolio. But is your investment process geared towards providing this liquidity?

Liquidity needs Liquidity typically refers to your ability to convert your investments into cash at the last traded price. It also refers to short-term cash flow and contingency needs.

Short-term cash flow needs refer to your requirement to meet life goals with investment horizon of five years or less, such as making down-payment for a house. Contingency needs refer to your requirement to have cash to meet emergencies.

Our focus here is on asset price liquidity, given the recent increase in asset values. Asset price liquidity determines your portfolio’s risk exposure.

A portfolio that loses 50 per cent has to gain 100 per cent to recover the losses. Whereas a portfolio that carries gains of 50 per cent has to decline only 33 per cent to give up all the gains. It is difficult to recover notional losses and easy to give up gains.

Compounding of equity returns can hurt because equity can generate both negative and positive returns unlike interest on your fixed deposit.

Because of asymmetric returns compounding, large notional gains in your portfolio can expose your investment to high risk unless you take continual profits. But that requires your portfolio’s asset price liquidity to be high.

Asset liquidity So, choose products where selling the investment is easy. Directly buy open-end mutual funds from an asset management firm and then set up an online transaction account with the firm. This allows you to sell units directly with the mutual fund from the convenience of your home or office.

The speed with which you can execute the transaction helps in improving your portfolio’s asset price liquidity. Otherwise, redeeming units offline could lead to procrastination in decision and expose your portfolio to high risk. You should buy exchange-traded funds (ETFs). It is easy to sell these investments, as they are listed on the stock exchange. Buy onlythe most actively-traded ETFs within each asset class — that is, buy the most active gold ETF, Nifty ETF and sector ETFs such as banking sector ETF.

If you directly buy bonds, choose ones that are traded relatively frequently on the exchange. For instance, tax-free bonds issued by government companies not only offer attractive tax-exempt interest income but are also frequently traded on the NSE. This gives you the opportunity to sell these bonds if you want to generate capital appreciation. Importantly, it reduces the risk on your bond investments.

Tedious route Liquidity is important to reduce your portfolio’s risk too. Consider two issues. One, Tier I of National Pension System (NPS) carries high risk as you cannot sell the investments without penalty before you're 60.

So, you should consider investing more in Tier II account, which moderates the risk, though the process of liquidating your investment is still tedious. And two, you should worry about asset price liquidity and how it moderates risk only if you are relying on capital appreciation for returns. Small wonder that you do not carry such risk on your bank fixed deposits.

The writer is the founder of Navera Consulting. Send your queries to >portfolioideas@thehindu.co.in

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