Investing appropriately will help build a cushion. Earn returns from such investments
Liquidity management is one of the most neglected part of an individual's financial management. Most people tend to think that liquidity management stops at maintaining some cash balance in one's savings account. Some maintain fair amount of cash in hand.
Unfortunately, both of these may not be the best way to maintain liquidity in your portfolio. Your portfolio needs liquidity to take care of your current expenses. Also, a margin of safety needs to be maintained. For that, have a liquidity margin typically covering three to six months' expenses. Three months' expense cover should be good enough for most. But, six months' cover is suggested when your earnings outlook is uncertain and when income can fluctuate, due to the nature of your job (say a professional or freelancer or someone in a sales function where the commissions fluctuate). For some, even the expenses can vary on amonthly basis. A higher liquidity margin will provide the additional cushion, in such cases and also when there is a loan to be or being repaid.
Liquidity can be maintained in one's bank account to the extent of what one may reasonably require for expenses, plus emergency (if any). Since savings bank accounts offer 45per cent per annum (before tax), it is not the most desirable avenue to park your money in, beyond the absolutely necessary level, may be one month's expense.
As the liquidity margin may not be touched for most years, we need to invest in a place which can offer better returns than a savings account. One of the places where such funds for liquidity can be maintained are banks' sweep-in deposits. These offer far higher returns than savings bank accounts. These deposits get created when there is more than a certain amount of money in one's savings account. For all practical purposes, the amount in flexi deposit is like money in savings account, as they are available for withdrawal anytime, as and when required (preferably in the short term).
The other desirable place to park the liquidity amount is ultra shortterm fund. These funds offer good returns of over 9 per cent in a year. What's more, the tax treatment here can be far more benign if invested in the dividend option (which would be the correct choice), the dividend distribution tax is at 13.5 per cent (paid by the fund house). For a person in the highest tax slab, this will translate into major saving. Ultra short term funds do not have exit loads. Hence, when required they can be cashed out.
You could also plan for events which are going to come up like upcoming premium payment, holiday funding, annual school fee payment and so on. To meet them without problems, we would have to create provisions for these events which more or less are certain. The other situation for which we need to plan is contingency. Contingency typically is an emergency, say medical or a financial emergency, which needs to be met.
In both these cases, we have a variety of instruments to contend with. Since the tenure is known in case of provisions, we can invest in an appropriate instrument. For instance, if an expense of ~50,000 is coming up in four 4 months hence, one can invest in a monthly interval plan and roll it over till it is required. If an expense is coming up in about 3months, a quarterly interval plan (QIP) would be more appropriate. At current rates, even an ultra shortterm fund would be a good bet. For somewhat longer tenures - say one year - a fixed maturity plan (FMP) of asimilar tenure would do the job. If the timing is rather uncertain, one can invest in a QIP and roll it over, be made in instruments which give stable returns and can be liquidated. The instruments company fixed deposits, where you may not get the money immediately on redemption. Add to that, bank deposits are safer than company deposits, though the later pays more than the former.
Though investing for goals and objectives should be an important part of your financial planning, liquidity margin, provisioning and contingency funding are equally important aspects. By investing in appropriate instruments, you will be able to build a cushion as well as earn reasonable returns from such investments .
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