Besides return and risk, investors also need to weigh the liquidity of the instrument they are putting money in
When choosing an investment instrument, most investors look only at the returns that the product could potentially offer. Some investors go a step further and examine the risk that the instrument carries. One criterion that most investors, except the seasoned ones, ignore is liquidity. Such oversight can have serious consequences at times.
To evaluate whether an asset is liquid, you need to weigh it on four parameters. One, check if you can convert the asset into cash without expending too much time and effort.
Two, evaluate if it carries default risk. Three, see if the asset will lose value if you need to liquidate it (that is sell the instrument and convert into cash) at short notice. And finally, you need to take into account if the instrument can be leveraged through alternative means.
Rasik Shah has a surplus of Rs 200,000 which he needs to invest in an asset for one year. At the end of the tenure, Shah will need this money to make the payment for an apartment he has just booked. For Shah, therefore, the most important consideration is that the investment should be liquid. Shah also needs to ensure that this asset does not lose value.
If he invests the Rs 200,000 in the equity markets and the value of his shares fall to Rs 1.5 lakh owing to a market correction, Shah would have a real problem on his hands bridging the gap of Rs 50,000 for the payment. When you are clear that liquidity is your prime consideration, as in Shah's case, then the four key tests mentioned above need to be applied.
Easily convertible into cash
Asset classes like equities and mutual funds can be easily converted into cash and, hence, can be classified as liquid. But, they are volatile. Of course, the safest and highly liquid way to invest money would be to put it in a savings bank account. But then your money would not give the optimal return. You would not be making the best possible investment decision in the circumstances.
In Shah's case, the prime consideration is that when it is time to make the payment for the apartment in a year's time, he should be able to convert his asset into cash without much effort. Assets like land and property are hard to convert to cash. Similarly, redeeming company deposits or bonds can take time.
An ultra-short-term debt fund or a money market (liquid) fund will be a good option in this case. These funds would provide slightly higher returns than a savings account, and at the same time, the possibility of loss of principal will also be minimal in these funds. Shah will also be able to get the money credited into his bank account within one working day whenever he needs it.
An investment is said to carry default risk when you could lose your principal by investing in it. Company deposits, for example, carry default risk. There have been umpteen cases of such defaults in the past.
Government bonds or mutual funds investing in government securities are generally not exposed to default risk. Bank fixed deposits (FDs) are insured up to Rs 100,000. Hence bank FDs can be considered to be free from default risk up to this extent.
No distress sale
This is an important parameter to evaluate. It is quite possible that it is easy to sell the instrument at short notice and get cash from it. But, if in the process you have to sell the asset at a discount, it would not classify as being highly liquid.
This problem is acute in the case of physical assets like property. This is an asset in which a lot of Indian have a very high proportion of their net worth tied up. If circumstances arise wherein someone has to sell his apartment at short notice, he will find it extremely difficult to get buyers, especially at present when the reall estate market is in the doldrums. If a buyer or two does come forward, he will shrewdly sense the seller's desperation. In case of such distress sales, buyers offer a heavily discounted price.
Gold is easily convertible into cash and is, hence, held by many Indian households as a store of value for emergencies. Even the lady of the house, who might not have a good knowledge of her family's finances, knows where the gold is and can pawn it at the neighbouring jewellery shop.
However, how much money you will be able to realise from gold will depend on the form in which you have held it. If the gold is in the form of jewellery, the making charges will be deducted, and the jewellery will also be assessed for purity.
In the process, you can end up losing a substantial portion of its value. With gold coins and bars, especially those that are hallmarked, you are likely to get a much better price.
Equity markets are quite liquid since it is easy to sell your holdings and get the money within three days. But, with equities, there is always the risk of losing value if the market moves in the adverse direction.
When you know your investment horizon, ensure that you put your money in an instrument that will mature at around the same time and can be liquidated without losing value.
Raise money through pledging
Liquidity of investment does not just mean that it should be easy to sell or surrender it. Other sources of liquidity also exist. For example, an asset can be pledged with a bank or a financier and money can be raised against it.
There are three key considerations here. First, the asset must not be too volatile as that will result in higher margin calls after the loan has been given to you. Second, look at the cost of funding. Loans against FDs and gold, for example, come at fairly attractive rates of interest.
Third, focus on the loan-to-value (LTV) ratio. The higher the LTV ratio, the more attractive is the instrument from the point of view of liquidity. Typically, equities and equity mutual funds have an LTV of 40-50 per cent while gold can have an LTV as high as 70 per cent as it is less prone to volatility. Remember, you can also borrow against some of your insurance policies and get a percentage of the surrender value.
In our focus on risk and returns, many of us tend to underplay the role of liquidity in investment decisions. When you have a known outflow, liquidity should become your primary consideration.
Get money when you need it
Anil Rego is CEO and founder, Right Horizons
Illustration: Uttam Ghosh/Rediff.com