Overview – How Can Someone Be Poor if They Have Lots of Assets?
In the world of investing, people are often discouraged from keeping too much cash on hand. That’s because having an abundance of cash sitting around idly represents a huge opportunity cost. Instead of gathering dust under a mattress, all that cash could instead be earning some kind of return, whether it’s from interest payments, dividends, or capital appreciation.
If someone has thousands of dollars in savings but has very few, if any, investments, investment advisors and pundits alike are quick to point out this major financial mistake – for the most part, this criticism is largely valid.
So, if an abundance of cash lying around is a problem, then the logical solution would be to deploy those funds in some productive manner, such as purchasing assets for investment purposes. Right? Sort of.
While having an abundance of cash lying around is certainly a problem, the same can be said for the other extreme: having an abundance of assets but little cash can also lead to all sorts of potential headaches.
It’s entirely possible for an investor to have an impressive net worth on paper but still struggle to pay for certain expenses because their balance of assets/cash is so skewed.
Getting Familiar With Liquidity
Before we discuss the problem of being asset rich yet cash poor, the first step is to understand liquidity.
Liquidity, put very simply, is a measure of how easy it is to convert a given asset into cash without drastically changing its market price.
Certain assets such as land or real estate have very low liquidity because it takes time to convert them into cash: a suitable buyer needs to be found, negotiations/talks need to take place, and a plethora of paperwork needs to be sorted out. By the time these assets are finally sold, it’s highly likely that the market price and selling price are vastly different due to all the negotiations and price jousting that took place.
On the other hand, other assets like equities are quite liquid because they can usually be sold at, or very close to, their current market price on any given trading day.
By definition, this means that cash is the most liquid asset. When looking at a balance sheet, specifically under the “assets” section, a company’s assets are listed in order of decreasing liquidity (i.e., the most liquid asset, cash, is almost always displayed first, with everything else following after).
Another way to think about liquidity is “how quickly an exchange of value can take place”.
When you purchase something with cash, both parties receive the value they want right away: you get the item/service that you want, while the seller gets cash which they can immediately use to make other purchases. On the other hand, you’d be hard-pressed to find someone willing to take a portion of some land as a form of appropriate payment.
Every asset has varying degrees of liquidity, and investors would be wise to understand what those degrees of liquidity are, which leads us to our next discussion.
What is Asset Rich, Cash Poor, and Why is it a Problem?
As you may have guessed, when someone is asset rich yet cash poor, this means that a sizeable portion of their net worth is tied up in assets, but they have very little (relatively speaking) cash on hand. An example would be someone who owns several properties worth a few million dollars, while only having a few thousand dollars of cash available.
At first, this may not even sound like a problem. Who would complain about having a high net worth, even if most of that value is derived from various assets? After all, it’s not unheard of for a large portion of a person’s net worth to be attributed to various assets such as securities, private businesses, and real estate.
However, when looking at our previous discussion about liquidity, the problem is made abundantly clear: different assets have varying degrees of liquidity, so if someone were to ever need cash at a moment’s notice and they needed to liquidate a variety of assets with varying degrees of liquidity, then they may not raise enough cash on time.
It’s easy to think that such a problem is only applicable to people who have multi-million dollar portfolios, but even those with modest portfolios can fall into the same trap.
Unless they live an extremely privileged life, people with financial resources will be on the hook for certain expenses. Regardless of how big or small these expenses are, chances are they will need to be paid for with cash.
Owning hundreds of shares is certainly a nice feeling, but those shares won’t be accepted as a valid form of payment when buying groceries, paying for your credit card bill, or when your landlord comes knocking for this month’s rent.
Therefore, investors are faced with the unique challenge of putting their money to work, while at the same time making sure they have enough money on hand to cover their living expenses. If that’s the case, how can an investor know what the right balance is?
How Much Liquidity Should an Investor Have?
If having adequate liquidity is an important consideration for investors to keep in mind, then how much liquidity should they have at any given time? Unsurprisingly, the answer is: it depends. Not only that, but the answer changes as an investor progresses through their life and investment career.
Imagine we have a 22-year-old investor. They’ve just started working, but still live at home. Additionally, they have no dependents (i.e., don’t need to support anyone else financially besides themselves). Other than some bills such as their mobile plan, memberships, insurance premiums, or maybe even car payments, other expenses (utilities, groceries, mortgage/rent) are covered by their parents.
In this situation, this young investor will need cash on hand to pay for the few expenses they’re responsible for, but because their parents cover other, larger expenses, and because they don’t have anybody they need to financially support, they can afford to tie up more of their money in their portfolio.
Fast forward and this investor is now 40 years old. They have their own family now, and because their parents have long stopped supporting them financially the bills they’re now responsible for paying all the bills. Despite these additional financial responsibilities, they now earn much more than they did 18 years ago, and because they’ve maintained their portfolio it has also become a major source of income.
At this stage in their life, they will probably want more liquidity because of all the expenses they must now pay, but because their portfolio has grown and are now earning more, they can likely still afford to tie up a decent amount of money in their portfolio.
Regardless of how many examples we go through, the point remains the same: an investor’s liquidity needs will change over time, and it’s their responsibility to constantly assess what those needs are at a given point in their life.
Since there are no established rules when assessing liquidity needs, finding the right balance will ultimately come down to an investor’s judgment, experience, and perhaps even some comparisons made with their peers.
“Asset Rich” and “Cash Poor” Don’t Have to Be Mutually Exclusive
Now that we have a better understanding of the dangers of having an abundance of assets but a dearth of cash, looking back on our previous discussions it almost sounds as if “asset rich” and “cash poor” are mutually exclusive. You can have high liquidity or lots of assets, but not both.
However, that isn’t necessarily true. Up to now, we’ve looked at the dangers of hyper-focusing on one extreme, but that doesn’t mean the solution is to go to the other extreme. More moderate solutions still exist.
It’s still possible for investors to put their money to work while maintaining adequate liquidity by being careful with the kinds of assets they wish to own. While some assets have poor liquidity, others can be sold for or converted into cash quite quickly.
For example, some guaranteed investment certificates (GICs) and bonds are redeemable in under a year, with some even being redeemable in just a few months. Returns may not be eye-popping, but if an investor insists on generating some return on their capital, no matter how small, then this could be an option.
Equities also have reasonably high liquidity since they can usually be sold on a given trading day with minimal hassle. The dividends they offer plus their capital appreciation are classic ways to generate returns. However, selling large quantities of a given equity (e.g., thousands of shares), or trying to sell equities that aren’t frequently traded may negatively impact their liquidity.
If an investor creates proper investment strategies and is constantly assessing their liquidity needs, then it’s possible for them to have a robust portfolio while simultaneously having enough cash on hand at all times.
Because different investors have different goals and liquidity needs, there are a plethora of approaches that can be taken to achieve this. But again, as we’ve said before, knowing the details ultimately rests on an investor’s experience, knowledge, and judgment.
Wrapping Up
Everybody has expenses they’re on the hook for, and many of them are usually paid for with cash. However, some people forget about this, and instead, use large amounts of cash to amass as many assets as they possibly can. Eventually, they discover that they don’t have enough cash on hand to meet their day-to-day expenses.
Being asset rich yet cash poor may sound like a problem only a select few will run into, but even people with modest means can fall into this dangerous trap.
Investors are especially at risk of this because many of them are so focused on continuously growing their portfolios that they can easily forget about their daily cash needs. Therefore, investors are responsible for making sure they understand what their liquidity needs are at a given moment in their life.
If done correctly, it’s possible to maintain a robust portfolio while still having enough cash on hand at a moment’s notice. However, knowing which strategies to deploy to achieve that is contingent on an investor’s knowledge, experience, and intuition.
