How Should You Consider Liquidity in Your Portfolio? | American Funds

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How Should You Consider Liquidity in Your Portfolio?

For most investors, some degree of liquidity — having cash on hand or the ability to quickly liquidate investments into cash without much penalty or hindrance — is important.

Certainly, using cash as your source of liquidity can make a lot of sense, especially as part of a well-planned, diversified investment approach. Your financial professional can help you decide just how much liquidity you really need and where you might invest any surplus to help you meet your financial objectives.

When It Comes to Liquidity, Cash May Not Be King

There is also a possible downside to holding too much of your liquidity in cash. Though it may be somewhat of a safe haven in periods of turmoil, the value of cash can erode over time. That’s because of inflation — a general rise in the prices of goods and services over time that can mean your money doesn’t buy as much as it once did.

Investors who like the liquidity of cash, but don’t want to be subject to the typical restrictions imposed by bank accounts, have some investment options they could consider. These alternatives are typically less volatile than stocks, but they do entail risk; it is possible for investments to lose money. Also, unlike many bank offerings, investment alternatives are not federally insured.

Other Types of Liquid Investments

If you want immediate access to your cash without penalty and are willing to take only minimal risk, one of the more traditional options is a money market fund. Indeed, financial advisors often view an investment in a money market fund as the equivalent to holding cash. But, it's important to remember that you could lose money even in a money market fund.

Compared with other types of mutual funds, a money market fund invests in relatively low-risk securities such as government debt, short-term corporate obligations and certificates of deposit (CDs). For those seeking a liquid investment with relatively little risk of capital loss, they remain a potentially attractive alternative to savings accounts and CDs. That said, in recent years the Federal Reserve's low interest-rate policy has meant that many money market funds have offered virtually no current yield to investors.

Are you comfortable with taking a bit more risk (in the pursuit of a little more income)? You might then consider investing in a shorter term bond fund.

Beyond offering a source of diversification for stock-heavy portfolios, shorter-term bond funds can potentially offer investors incremental income in a way that seeks to preserve their initial investment. Income from shorter-term municipal bond funds has another potential benefit — generally, it’s exempt from federal income taxes and, for some funds, local and state income taxes as well. In part because of potential tax benefits, the before-tax yields paid by municipal funds tend to be lower than those of taxable bond funds.

Finally, for people who prefer an investment with more of a singular focus on seeking to preserve purchasing power, inflation-linked bond funds are another possible option worth considering. These types of funds typically invest mostly in U.S. Treasury Inflation-Protected Securities (TIPS), which are bonds backed by the full faith and credit of the United States government. Unlike standard U.S. Treasuries, however, the face value of TIPS and the interest they pay investors move up and down with inflation — the general rise in the prices of goods and services.

The types of liquid investments that may be right for you depend on, among other things, your time horizon, objectives, risk tolerance and overall financial health. Your financial professional can help you decide what may be the most appropriate investment portfolio to meet your needs.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing. 

The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings. While not directly correlated to changes in interest rates, the values of inflation-linked bonds generally fluctuate in response to changes in real interest rates and may experience greater losses than other debt securities with similar durations.