Beware the 'liquidity trap' in today's volatile markets

Warren Buffett famously said, "Only when the tide goes out do you discover who's been swimming naked."

That's true in volatile markets like those experienced in emerging markets this year in anticipation of a Fed rate hike.

Warren Buffett's adage is a reminder that timing is everything when it comes to investments. Unfortunately life doesn't always co-operate with market cycles and that's why liquidity is a much overlooked component of financial planning.

In Singapore there are many fixed-term retirement products on the market. They often include significant upfront fees, locked in monthly payments over long periods (25 or 30 years), high exit penalties, and hidden fees.

Too often we set and forget these things. But what about when the unexpected happens? One-size-fits-all products with low liquidity can leave you high and dry, just when you need your savings the most.

That's where liquidity planning becomes important as part of a holistic savings strategy.

Unfortunately, liquidity comes at a cost. The most basic form is cash in the bank. It's not going to yield much in return for your deposit; around 0.05% in an account at a Singapore bank on a deposit of less than $250,000.

When accounting for inflation – that becomes a negative savings rate. You are paying for the privilege of depositing funds in the bank and accessing those funds at will.

Or you can try trading your way through volatile markets. The difficulty here is in timing the markets. "Good luck with that," as Terry Smith, the renowned fund manager at Fundsmith, would say. Timing markets is something even the best investors consistently fail to achieve.

There are several ways that investors can avoid the 'liquidity trap'.

1. Keep a portion of your funds in cash, or near cash. Emergencies happen when you least expect. Three to six months of your salary can help relieve your anxiety when they do.

2. Put most of your investments in liquid investments. That could be a portfolio of shares, bonds, mutual funds, and/or alternative funds. It is important that they provide at least monthly liquidity (meaning you can take out funds at relatively short notice) and that enough volume is traded to allow you to liquidate your holdings.

3. Have enough liquid investments to cover the unexpected, then consider less liquid investments. Make sure you are well compensated in long-term investments, for locking up your capital.

Recent years have shown us that lack of liquidity is a wealth destroyer. We all know the financial crisis was a major liquidity crisis. Recently in June we saw more than 1,300 Chinese listed entities suspend their shares from trading during that market’s extreme volatility – leaving investors unable to liquidate their holdings.

So while investors should always have a view on the long-term, in today’s volatile markets they are well advised to factor liquidity into their retirement planning.