What is Liquidity and Its Role in Financial Planning?

In this policy, the investment risks in the investment portfolio is borne by the policyholder

The term "liquidity" refers to the ability to convert an asset into cash. If it is easier to convert an asset into cash, it is said to be more liquid. Cash is usually regarded as the most liquid asset. It is simple and quick to withdraw money from an ATM or transfer money between bank accounts.

Cash in hand however is stagnant and even depreciates over time if left uninvested. A savings account with a bank fetches a small rate of interest but immediate access to liquid funds when required. If you are looking for a slightly higher return on your capital, you can opt for other instruments that allow you grow your money till it is needed.

Liquidity versus investment returns

A savings account is the most liquid form of investment, while an FD with a bank or an NBFC will fetch higher return at a cost – some penalty is levied if you withdraw the capital within the stipulated period. While planning for your financial goals, you can also consider short term options like liquid mutual funds, which tend to offer better returns than FDs and can be redeemed without a hefty penalty, but also carry a greater risk since they are governed by market volatility.

Role of Liquidity in Financial Planning

In order to balance your short, medium, or long-term goals, liquidity plays a critical part in financial planning. Several factors make liquidity crucial in financial planning:

1. Highest Liquidity

   It is typically an ideal scenario to save the equivalent of six months' worth of your income in fixed deposits as cash reserves or emergency funds. This is merely a general guideline, and based on unique circumstances, the precise amount may change for different people. This reserve can be leveraged in case of extreme necessity and an emergency. Moreover, you can maintain the necessary amount in your savings account to cover regular expenses.

2. Medium Liquidity + Stable Returns

   You require assets with less liquidity if your financial goals are medium-term i.e. more than a year away yet fall within the next five years. In order to grow your wealth in the medium term, you can invest in instruments such as debt funds which offer reasonable returns, depending on your investment tenure. Low cost structure, comparatively constant returns, strong liquidity, and sufficient safety are a few key benefits of investing in debt funds.

3. Lowest Liquidity + Highest Growth

   You can leverage long-term investments to achieve your financial objectives. Some investments, such as NPS, ULIPs, and PPF, may offer less liquidity but over time, they may provide greater growth. These investments are ideal if you want to put money aside for things like your retirement, child's education, buying a house, etc.

How does Financial Planning Maintain Liquidity?

You will be able to estimate how much money you'll need at each stage of life if you have a sound financial plan in place. It helps you plan your current and future cash flows, ensuring that you always have sufficient funds in hand. Following are the typical situations:

1. Car Purchase/Replacement

   In case you need to buy a new car or replace with a new one, following options can be leveraged:

   1. Public Provident Fund (PPF)

      PPF offers partial withdrawals after 6 years (from account opening date). You can leverage this instrument to pay for your new car in full or as a down payment.

   2. Unit Linked Insurance Plans (ULIPs)

      Partially withdrawing from ULIP plan is also permitted after five years and this option can be used to pay partially or fully for your purchase. In case you have invested in multiple ULIP’s, you can decide to take money out only for one or two funds to meet your goal.

   3. Mutual Funds

      Mutual funds are one of the best ways to grow your wealth. Depending on your risk profile, you can invest in equities and debt mutual funds and can make redemptions when required.

2. Child’s Education

   If your child is under 5 years of age and you know that you will need a substantial amount of funds for his college studies and expenses, you may plan your investments as per below options:

   Note that while partial withdrawals are permitted after six years in PPF and come with 15 years of maturity, ULIPs typically come with a larger investment horizon like 15 years and are a good tool to grow your wealth.

3. Your Retirement

   It is advisable to start saving for retirement as soon as you begin to make money. Below are good options to look at:

   1. National Pension Scheme (NPS)

      A normal withdrawal from National Pension Scheme (NPS) is only permitted after you turn 60 years old. NPS comes with options where you can choose the level of exposure in equity or government securities as per your risk appetite.

   2. ULIPs

      ULIPs are used to provide a regular pension that is tax-exempted and offers partial withdrawal.

      Owning liquid assets enables you to cover necessary living costs and respond to requirements as they happen. Holding liquid assets and having access to liquidity have a price, however. Hence, it is better to park funds into investments that increase your wealth over time, to guard against inflation as well as save for financial goals.

Related Article

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• Grow Your Wealth by Investing in Assets
• 5 Easy Ways of Making a Habit to Save Money
• How to Achieve Short-Term Goals with Systematic Financial Planning?
• The Balancing Act of Spending & Saving

ARN - ED/05/23/1932