When it comes to our financial lives, we should remember to “save for a rainy day.” Financial planners suggest that we have an emergency reserve equal to three-to-six months of our essential living expenses. It should be in a safe, stable vehicle such as a savings account or a money market fund. If you don’t have a sufficient reserve, make it a top priority. The easiest way to address the shortfall is to transfer a portion of your paycheck every pay period directly into a savings account. If you dip into your emergency fund, replenish it as soon as possible.
In addition to an emergency reserve, you need to think about your overall liquidity. Liquidity is a term from economics that indicates how easily an asset can be converted to cash. Some asset classes are more liquid than others. Cash and money market funds are the most liquid assets. Stocks and bonds are usually liquid. During periods of financial turmoil, however, you may not want to convert these assets to cash as values will likely be depressed. In these situations, people may be forced to sell what they can rather than what they should, which can depress values further. You should also consider the liquidity of your accounts. Retirement or education accounts may hold liquid assets, but the accounts themselves have withdrawal restrictions and penalties and are, therefore, less liquid.
During a period of widespread economic dislocation, illiquidity plays a significant role, which in turn has an impact on both Wall Street and Main Street. In good times or bad, all of us need to maintain an adequate emergency reserve and fully understand the overall liquidity of our assets.
