Is liquidity a function of your investment horizon? For instance, if you have a short-term goal, should your liquidity requirement be higher than if you have a long-term goal?

Here's addressing the relationship between liquidity and investment horizon.

Liquidity requirement Liquidity refers to your ability to sell your investments at the last traded price. Now, your liquidity requirement is a function of your portfolio composition which, in turn, is determined by the length of your investment horizon.

Life goals are defined in two time blocks only — goals that have investment horizons of five years or less, and goals that have investment horizons of more than five years. In a goal-based portfolio approach, a portfolio with an investment horizon of five years or less should not contain equity investments, as they are volatile. What if the market tanks during this period? You will have less time to recover your losses.

One way to avoid market risk is to invest in bank fixed deposits with maturity equal to the length of your investment horizon. Since fixed deposits are not traded, the issue about liquidity does not arise. So, in a goal-based approach, you do not require liquidity for life goals with investment horizon of five years or less. The risk is different for portfolios with investment horizon of more than five years.

Such portfolios contain equity investments and therefore subject you to two associated risks — asymmetric returns effect and sequence of returns risk (SORR). Asymmetric returns effect refers to the fact that it takes more effort to recover losses than it takes to give up unrealised gains. For instance, your portfolio has to gain 25 per cent value to recover unrealised losses of 20 per cent. Your portfolio has to decline by only 17 per cent to give up unrealised gains of 20 per cent. Consider SORR. You invest and immediately thereafter, the market declines. Or you sell some of your investments and immediately thereafter, the market climbs up. In both cases, your returns will be lower than if the scenario was the other way around.

This is SORR — the risk that you will have bad returns because of the sequence of positive and negative returns. You are exposed to this risk because you typically invest through systematic plans. All risky assets subject you to asymmetric returns effect and SORR. Now, you cannot avoid SORR unless you avoid systematic plans and make only lumpsum investments.

But that is not always possible, especially when you are pursuing multiple life goals. You can, however, moderate the asymmetric returns effect by capturing unrealised gains based on predetermined rules. And that means your liquidity requirement needs to be high in order to book your profits, as they can be wiped out in quick time.

Therefore, if your investment horizon is more than five years, liquidity assumes more importance. But the typical view about liquidity requirement is different from the view above.

Alternative view You could argue that your short-term portfolio will require more liquidity than your long-term portfolio. Why?

You require proceeds from your short-term portfolio sooner, rather than later, to meet your objectives. You need liquidity from your long-term portfolio only if you need money for emergencies in the short term. If that is the case, you should be comfortable investing in illiquid assets, such as real estate, to meet your long-term investment objectives. You would then need liquidity near the end of your investment horizon to convert your investments into cash.

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

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