|Course 502: Building a Portfolio, Part 2|
Liquidity is the ability to readily convert an asset into cash. Examples of liquid assets are stocks and bonds. Examples of illiquid assets include real estate and venture capital.
There is a key difference between real liquidity needs and perceived liquidity needs. Perceived liquidity needs include things that you may want but aren't really necessary. Real liquidity needs typically fall into one of the essential categories listed below, which you need to consider when developing your financial plan:
Emergency Cash. Financial advisors recommend that you keep three to six months of spending cash on hand in case of an emergency. Set aside this money in a money market fund and do not consider it to be part of your investment portfolio.
Goal Spending. Investments for short-term goals, such as those three to five years out, should be very liquid.
Taxes. If you can estimate what you owe in income or estate taxes, set aside money in cash equivalents that mature no later than the due date.
What about the taxes you'll have to pay on profitable positions that you have sold? Assets that are held for less than one year and then sold are taxed at the 15% capital-gains tax rate. Those held for 12 months or more are taxed at a 5% rate. It would make sense, then, to hold onto an investment for more than 12 months and enjoy the tax advantage.
Investors with a significant concentration in one stock that has a low cost basis (which simply means a low purchase price relative to the stock's current price) will need to pay large capital-gains taxes at the time of sale. It may be tempting to defer the capital-gains tax indefinitely by just holding on to the investment. But be careful: The risk of loss from a portfolio that has a large concentration in one stock may outweigh the tax-timing decision. Instead, consider selling portions of the low-basis stock over time. This will reduce your investment risk while still deferring some of the taxes.
Investment Flexibility. To be able to take advantage of market opportunities as they arise, make sure about two thirds of your portfolio can be liquidated within a few days or weeks.
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