The answer depends on the costs and the benefits of holding liquidity.
The benefits include the ability to avoid the costly sale of illiquid assets to fund spending needs. Households with a higher probability of near-term spending needs, such as a business owner or a high-earning manager in a volatile industry, will optimally hold greater liquidity. A homeowner will also hold greater liquidity, since maintenance expenses can be lumpy. Highly risk-averse households may also prefer to have greater liquidity in order to prevent undesirable variation in spending goals. Each household may even have a dollar amount of liquidity that it needs to maintain in order to feel financially secure.
The costs of liquidity can be larger than many individuals realize. First, liquid assets miss out on an illiquidity premium. Think of a liquidity premium as the difference between returns on a highly-liquid account, such as a money market savings account, and a less liquid asset of the same safety, such as a Certificate of Deposit (CD). The investor also loses out on the term premium, or duration premium. Holding longer-term safe assets traditionally provides a higher expected return.
Another cost of liquidity is that liquid assets provide no risk premium. For this reason, they should be considered part of the safe portion of an investment portfolio. For example, a portfolio that contains $600,000 in stocks, $350,000 in intermediate-term government bonds, and $50,000 in cash, consists of 40% safe assets, the combined total of bond and cash holdings.
Liquid assets are also poor choices for tax-sheltered accounts. Although the interest is taxed as ordinary income, because they have no risk or illiquidity premiums, the gross returns on liquid assets are lower, which reduces the benefit of sheltering. Also, because of potential tax and additional penalties on withdrawals, liquid assets can lose their liquidity if held in a tax-sheltered account.
A better safe investment for tax-sheltered accounts are tax-inefficient bond investments.
So there will always be an annual wealth loss from holding liquidity. In turn, holding liquid assets needs to provide enough benefit to outweigh these costs.
Cash provides the liquidity and security that all investors want. This is why it can be tempting to make sure we have a large amount of our portfolio held in cash. This is often called an emergency fund.
But cash is costly.
Every year, investors can lose thousands of dollars in opportunity losses because they invest more in cash than they need. When assessing our ability to withstand a financial emergency, it’s also important to consider other assets that can be quickly turned into cash at a low cost, such as cash-value life insurance, home equity, taxable bonds, and stocks with little or no capital gains.
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