An investor must achieve a fine balance between immediate cash needs and life goals
It is important to avoid decisions that can harm your life goals. Consider the desire to invest in highly liquid investments. Liquidity refers to your ability to sell an investment at a price that is not significantly affected by the urgency with which the investment is sold.
You can sell your real estate at a distress price if you need to raise cash urgently, but you may have to wait for a while if you want a fair price. Liquidity also refers to your inability to sell your investment because of its lock-in feature.
In this article, we discuss the impact of highly liquid investments on your financial well-being.
When lock-in is good
True, we all need liquidity to meet unforeseen expenses. But the desire for high liquidity also depends on your emotional state.
Typically, those who are financially insecure are more likely to prefer liquid investments than others.
Note that you may have a comfortable lifestyle and reasonable income and yet be financially insecure.
Nonetheless, it is important to give up liquidity for your goal-based bond investments. Why? Instead of keeping too much money in your savings account or short-term deposits, invest in fixed deposits that align with your life goals.
That is, if you must achieve a life goal five years hence, then invest in a five-year deposit.
This may seem obvious, but many invest in short-term deposits despite having long-term goals for two reasons.
One, the feeling of insecurity drives them to make investments that can be quickly converted to cash. And two, long-term deposit rates may not be adequately high compared to short-term rates.
For instance, the difference between a one-year deposit and a five-year deposit offered by a large bank is just 0.50 percentage points. Yet, aligning deposits with life goals denies easy access to money, and therefore, prevents you from spending it for other purposes.
Also, you do not have to look for reinvestment opportunities till you need the money to meet your goal.
When lock-in is harmful
For goal-based equity investments, you should avoid products that force you to lock in your money for a specified period. Why? For one, you are exposed to the risk of heavy losses as the market could decline during the lock-in period.
For another, you need liquidity to sell (rebalance) some of your investments annually so that the proportion of equity in your portfolio is not high because of unrealized gains. However, the lack of a lock-in feature could tempt you to liquidate your investments before the end of the time horizon for a life goal! You typically set up a systematic investment plan (SIP) on an equity fund. You can be tempted to stop the SIP if you feel financially insecure. Worse, you may liquidate the entire investment to meet other expenses that may seemingly assume more importance at present. Both actions can be harmful to your financial well-being as they could jeopardize the originally intended life goal.
So, how should you do this? Set up the SIP in your spouse’s name. Importantly, your spouse should keep the login credentials. If you are unmarried, the login credentials can be managed by your parent or your sibling. This process locks you into the investment because stopping the SIP or liquidating the investment requires the other person’s authentication. You should create an emergency fund to take care of reasonably foreseeable liquidity needs. That way, it will be emotionally less stressful to lock in bond investments through the time horizon for a life goal and to avoid liquidating your equity investments to meet other expenses.
The saying “[w]e have met the enemy and he is us,” popularly attributed to Pogo, the comic character created by Walt Kelly, could just as well refer to our personal finance! Moderating our biases improves our financial well-being. An unreasonable desire for high liquidity is one such bias.