You may hear investment professionals talk a lot about liquidity but it can be a confusing subject as either too much or too little can negatively affect your portfolio. So what is it and what should you do about it?

Liquidity refers to how easily an asset can be converted into cash without affecting its market price. Cash, being the measure for this, is the most liquid, and because it can be used to buy any other type of asset. Property, antiques and other physical assets are considered illiquid – they take longer to sell. Stocks and shares fall somewhere in between.

The advantages of being able to cash in an investment quickly are obvious; if you need the money that sale will generate you can have it without a long wait. On the flip side, investors are encouraged to buy into less liquid assets (that allow less ready access to their money) as these types of investments can offer higher returns. This is known as the liquidity premium.

Cash in the bank will get you virtually nothing in terms of returns these days. Most savings accounts barely beat inflation. But if you have an emergency which means you need access to cash fast – say your house gets flooded and you don’t have insurance so you must pay for the damage yourself – that cash in the bank is there immediately.

By comparison it can take months to sell a property. But you are rewarded for that wait – the National Council of Real Estate Investment Fiduciaries found the average 25-year return for commercial real estate to May 2019 was 9.4%. Somewhere in between in terms of liquidity, stocks and shares also tend to offer mid-level returns; between 1984 and 2019 the FTSE 100 averaged 5.8% a year according to Bloomberg.

Liquidity in a portfolio is a balancing act. It is generally considered important to hold assets with varying levels of liquidity to create a well-diversified range of investments. Too much liquidity and you miss out on returns, too little and you could be stuck in a cash emergency.

Things beyond your control can affect the liquidity in your portfolio. For example, following the September 11th 2001 attacks the New York Stock Exchange and NASDAQ markets closed for almost a week. Investments on those exchanges instantly became illiquid because investors were unable to either buy or sell them.

Investor panic can also cause liquidity to dry up. This happened in 2007 when concerns about collateralised debt obligations led floods of investors to dump them; it destroyed their value, made them unsellable, and so illiquid. This triggered the global financial crisis and ‘credit crunch’, where financial institutions lost confidence in lending to each other, and us, removing liquidity from the system until central banks supplied some via quantitative easing.

As a general rule of thumb consider thinking about liquidity and portfolio construction in terms of time; illiquid investments can work if you can hold on to them till the right moment when they have grown in value, but you could lose heavily if you are forced to sell them at the wrong time. Holding some liquid assets like cash in your portfolio won’t make you any money, but it will guard against this erosion of your overall returns.