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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Have Money? Risk is Inevitable! [Part 3 - Liquidity Risk]

The moment you have money...the risk begins. Inflation will start eroding its value day-by-day, year-by-year, decade-by-decade. In fact, it would wrong to use the word ‘risk’ here. Risk is something which may or may not happen. But inflation is a near certainty.

To beat inflation, earn some returns and make your money grow you have to invest it somewhere. When you so do, you are exposed to different kinds of risks depending on the product you choose.

Liquidity Risk
Keeping a lot of idle cash in bank means we are loosing opportunity to earn higher returns thru’ suitable investments.

Too low a cash balance can also be a problem. If we suddenly need money, we would have to prematurely liquidate our investments. This, as we are all aware, has a cost. There is a penalty if we close our FD before the due date. Mutual funds charge an exit load if the investment is redeemed before a specified period. Or the markets are down and we may have to sell our bluechips at lower prices.

Sometimes the investments cannot be converted to cash, even at a cost. For example one may not be able to prematurely close a Company FD or withdraw from the PPF account.

Lack of a proper balance between cash & investments is what is generally called the liquidity risk (or the asset-liability mismatch). Sure, one can never maintain a perfect balance...all the time. But one can definitely minimize the loss due to the liquidity risk.

As a thumb rule, liquid money equivalent to 2-4 months’ of our normal expenses is likely to achieve a fair balance.

This money should be easily accessible. For example, some portion could be kept at home as cash and the rest in your savings account, which you can withdraw anytime, anywhere using your ATM Card. (Though, of course nowadays banks do offer fixed deposits linked to your savings account. Thus, you can not only earn more interest than the savings account rate, but also withdraw the money as and when you desire).

Another strategy to manage this mismatch is to build a portfolio with different maturity profiles. You could spread your investments across short term, medium term and long term products. This will ensure availability of money across all time frames.

Besides, given that nowadays it is possible to get lifetime-free credit cards, you can keep a spare credit card that you will use only in case of emergencies. This is a good alternative to keeping too much idle cash. You must, however, ensure that this amount is cleared on or before the due date; since the interest cost on unpaid credit card balances is exorbitant. 

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