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Financial Information for Senior Military Officers

Liquidity Risk...Do You Consider It When Making Investment Decisions?

Liquidity Risk...Do You Consider It When Making Investment Decisions?

I read an email the other day from an acquaintance.  He had some stock in a closely held corporation and was trying to sell it to "pursue other opportunities".  A month or so later, I received another email from him about the stock.  It was now "on sale" with greater discounts for buying larger lots.  Made me think...this individual didn't think about liquidity risk when he purchased the stock.

Just what is liquidity risk?  My CFP® textbook defines liquidity risk as follows:

The degree of uncertainty associated with the time it takes to sell an investment with a minimum of capital loss from the current market price.

In other words, "Will you be able to sell your investment quickly and at full price?"

Many times individuals will neglect this risk when making purchases or deploying cash.  Here are some examples.

Your House/Mortgage.  The great American Dream is to pay off (and then burn) the mortgage.  When you do this, you are in effect deploying your cash into a very illiquid asset.  We all know that it normally takes months to sell a house and you're going to pay a lot of commissions and expenses to sell it.  Beyond that, your house is an all or nothing sale.  You can't sell a part of the house when you have an unexpected expense.  Before you pay off your mortgage make sure you have the liquid assets you need to cover planned and unplanned expenses

Annuities.  Virtually all annuities have some sort of surrender charge if closed in the first few years.  This in effect ties up your money for 7 -10 years.  For those years, your investment is pretty illiquid

Non-Traded REITS.  There are two types of REITS.  Those traded publically and those that are not.  Non-traded REITS can only be sold during certain times and the price is notoriously hard to value.

Limited Partnerships.  These types of investments are common in oil and gas drilling and real estate.  To sell your shares you need to find a willing buyer...basically on your own.

Closely Held Corporations.  That start-up company may sound great.  If you buy stock in it, be prepared to hold it for a long time.  Stock of closely held corporations is so hard to sell the IRS even allows a reduction in the value of these stocks when valuing an estate for estate tax purposes. 

Retirement Accounts (401(k), TSP, IRA, etc.). Think about it.  You can't get these funds until age 59 1/2 without paying a penalty (with some exceptions).  I've seen it happen.  An individual had the goal of opening a franchise after retiring from the military.  The only investment he had was TSP.  If he wanted to access these funds he would have to pay penalties (there are other options, but that is for a different discussion).  Pretty illiquid until you're in retirement.

I'm not saying that you should never own these assets/investments.  That should be pretty obvious when Retirement Accounts are on the list.  But...make sure you do a thorough review of all risks, including liquidity risk before you deploy your cash into any asset.  Or, we'll be happy to do that for you.

TSP and Your Estate
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