Managing Liquidity Risk with PEMDAS

Written by Pat
Content Producer
"In 2019, I made over $10,000 in net profit from investing alone.​"

​Edited by Tera

Investing: The Risk We Can Squash

I want to talk about a type of investment risk we can manage and how that relates to some strategies in investing I’ve come to trust. 

The type of risk is called liquidity risk. It’s the risk involved with investing capital that subsequently becomes necessary for another transaction: a debt, bill, rent or the purchase of a good, essential or otherwise. 

For instance, if you open a CD for 10,000 USD, only to need that money for your child’s tuition and pull out of the CD early, incurring the early withdrawal fee, that was liquidity risk exposure.


Or if you invest 200 USD in bitcoin on the 5th of the month, then use it to pay for your Domino’s pizza on the 8th, that is liquidity risk exposure.

Here’s the textbook definition: 

If a person, business, or corporation cannot meet its debt obligations comfortably and then pulls out of investments to meet those debt obligations.

I expand beyond “debt obligations” to include all financial decisions that result in a person pulling out of an investment, because real people like you and me can make these decisions everyday. I may pull out of an investment to pay for rent, but I may just as well pull out of an investment because I need the money to play in a basketball league in the coming season. Or I’m mad hungry for pizza.

The reason we should  focus on liquidity risk is because it can be optimized to a healthy minimum, effectively zero. In other words, liquidity risk is a risk we can manage.

And if we are to invest sensibly, it is a risk we must manage.

Why?

Well for one, timing is everything. This is true for so many things, but it’s paramount for investors while handling their capital.

Writing now, amidst the 2020 Coronavirus pandemic and the resulting financial downturn, there are some great opportunities to buy into stocks that have dove below record highs. 

Now if I needed that money to pay next month’s car payment, I would be exposing myself to substantial liquidity risk. And if I planned to make extra money needed through the investment to make my car payment for next month, that is an extra layer of liquidity risk. Let it be known that when it comes to investing, there is no fast money. 

So if it works out in that scenario, I’m lucky, not smart. It is never wise to pay off future payments with expected profit because expected profits aren’t profit, yet! If the time for the payment comes around and the investment hasn’t hit the projected, hopeful value, the tides are going to roll out to expose me cold, naked and vulnerable. Nobody wants to see that. 

And more importantly, you as the investor should never want that.

That means two things: we need to budget for the future and have a safety net before investing.

These two go hand-in-hand. We need to know what expenses are coming month-to-month to organize our money into at least three bins: the bills and debts bin, the savings/safety-net bin, and last but not least, the investment cache. Without setting aside money for our bills and debts, we will accidentally mis-budget, sometimes requiring us to pull out of others bins. We should never have to do that!

Without substantial savings we still have liquidity risk because we have no buffer against needing to pull from our investment cache. Our savings is to cover unexpected costs, emergencies or unplanned big purchases; it insulates us from ever needing to pull out from our investment cache while still paying for what we want and need. 

This is crucial for so many reasons, one of which is that the stock market is over the long run always growing.

DOW Jones 100 Year Historical Chart Y: DOW value, X: Calendar Year — MacroTrends.net

By setting aside the necessary money for bills and extra money for those inevitable rainy days, we can safely and patiently take positions in the stock market and watch them grow.

If we invest capital that we can’t let grow for a while, we risk having to pull out an investment in a short-term downswing. It’s like trying to rush cooking a chicken and then having to pull it out raw, burnt, or both. 

If we invest capital we can let mature indefinitely, we are so much more likely to extract gains from the very same investment. We can put the heat on low, set it aside, and baby we got a stew goin’.

Photo and economic advice credit: Carl Weathers, Arrested Development

Both in cooking and in investing, preparation is key. To get the timing right in a meal, things have to be cut and prepped before anything hits the stove. Extending the analogy, to have the opportunity to invest in downswings and to wait them out instead of selling to get through them, we have to already have budgeted and grown our rainy day months fund.  

In order to optimize decisions based on timing, we have to have our house in order.

Which brings us to the last thing we’ll discuss: priorities and order of operations. In math it’s also called PEMDAS, an acronym for the order in which mathematical functions are to be done. We multiply before we add, do exponential powers before either, and parenthesis comes first!


For financial PEMDAS, high interest debt comes first! With credit card interests up to 29.99%, it takes an impressive amount of hubris to expect such a gain in your investments to appreciate in time for each and all of your credit card payments. Again, there’s that liquidity risk. If your standard income can’t cover your high interest debt and your other bills, declaring bankruptcy is more prudent than investing out of that hole. (You can nurse your ego after the dust settles.)

After high interest debt comes other debts and necessary bills like student loans, rent, phone bills, and car payments. 

Next would be shoring up the rainy day  months fund until it is adequately sized. Six months of expenses is the commonly referenced target, very pertinent to the current times of Coronavirus. And in light of the pandemic, recommending three months (not uncommon pre-Covid) sounds ill-advised.

Then, finally, if any cash is left, it can become capital for investing. This financial PEMDAS is right no matter what sort of money you get, be it your monthly salary, lump-sum contracts, lottery winnings(?!). With new money it’s high interest debt first, then other debts and bills, then savings, and then investing. 

The only exception to this is when your debts and savings are already handled and you make money in your investment cache. In that case, you can keep investing it!


P - Prioritize paying high interest debts
E - Essential expenses (those bills!)
M - Money for (six) Months (The rainy day fund, but really rainy months fund)
D- Don’t go further until you’ve taken care of the above!
A- Additional cash for investing (finally!!!)
S-  Sit back and relax (until any of PEM become an issue again).

Another way to think about all this is that invested money is money you should have already budgeted to never need. It’s money, for all intents and purposes, you could lose. And that’s important, because it can be lost. But more importantly, that’s how you should have already sorted out your budget. You need to be okay with losing it, so you don’t feel rushed. 

That’s the way you make the gains.

Summary:

• Don’t invest money you know you’ll need. Avoid liquidity risk by budgeting responsibly!
• Prioritize where your money goes: high interest debt first, then bills, then the rainy day fund (six months expenses). What’s left is investable! 
• Prepare for the bad months and the downswings. Not just to survive, but to thrive (by investing cash you can afford to let go of when prices are low)!
• Only invest money you’re prepared to lose, so then you can patiently wait for it to make profits. ​