Why liquidity is not important

Many of us may face a dilemma when it comes to locking-in our investments. We may have to choose between, say, investing in long-term fixed deposit and short-term deposit with roll-overs. Similarly, we may sometimes have to choose between closed-end funds and open-end funds. Such choices are not easy to decide. In this article, we show you how to make optimal choices regarding locking-in your investments.

Liquid Vs Locked Investments

Suppose your investment objective is to buy a house six years later. Should you invest in six year cumulative fixed deposit or in one-year deposit and roll-over the investment every year for the next six years? Similarly, should you invest in open-end funds or closed-end funds?

We typically find that individuals prefer open-end funds and one-year fixed deposits with roll-overs. Why? The rationale is simple. What if you need money any time during the next six years? Agreed, investing in one-year deposit provides you liquidity, but it comes at a cost. What if interest rate declines during the six years? You will have to renew the deposit at a lower rate. Investing in a cumulative deposit, however, helps you lock-in to the interest rate for the entire period.

The choice of open-end fund is quite another matter altogether. Suppose there are two funds with identical portfolios but one is an open-end fund and the other, a closed-end fund. The fund manager of the open-end fund will maintain more cash in her portfolio compared to the manager of the closed-end fund. This is because the open-end fund has to meet redemption requests on a continual basis.

Now, expected return on cash is lower than the expected return on stocks and bonds. Hence, an open-end fund will have lower expected returns than a closed-end fund with the same portfolio structure.

So, your choice of open-end funds and one-year deposits could lead to unnecessary cost for liquidity that you may not require!

Liquidity bias

Your concern for liquidity is not unusual. You may genuinely worry about meeting emergency requirement in the short-term, even when you are investing for a longer period. Often, however, your concern for short-term liquidity comes only when you are told that the investment will lock-in your money for a certain period of time!

Behavioural psychologists call this psychological reactance. It is the psychologists' way of stating that we want something even more when we are told that we cannot get it! In this case, you, perhaps, did not really want the money in the short-term. But when an investment prevents you from withdrawing money in the short-term, you simulate scenarios and reasons as to why you may require the money during the six years!

We suggest a simple solution to moderate this bias. First, set up an emergency fund. Keep this money in an investment, which you will not use for purposes other than to meet emergency requirements. This includes medical emergencies and money needed to meet household expenses if there is loss of income. This investment can be maintained in a savings bank account or such investment where there is no risk of nominal-capital loss. Besides, you should be able to withdraw money whenever required.

With the creation of an emergency fund, you will not have the urge to settle for short-term fixed-deposits and open-end funds. Your investment would then be more optimal, as it would be tied to your investment horizon.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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