Liquidity is the ease an asset can be converted into cash without incurring significant costs. Cash, by definition is the most liquid asset. On the other hand, something like a 1st edition base set PSA 10 Charizard is not very liquid at all. It would be rather difficult to find a buyer with the funds available to pay such a high price. And at the same time, such a delicate item will require quite a bit of costs incurred relating to the exchange.
Ultimately we want to find a balance between taking on an acceptable amount of risk and maximizing our rewards. We can categorize our liquidity requirement by tiers from 1, being the most liquid to 5, being the most illiquid.
Operating is cash that will cover your immediate needs such as food, transportation, rent and other bills. You should expect to spend this money within one week or one month. This can be supplemented by paychecks if you are working for an employer.
An emergency cash reserve should cover between 3 months to 12 months worth of expenses in case of an event such as job loss or unforeseen expenses. Your emergency cash reserve should be kept fairly liquid where most of it (at least 3 months) can be withdrawn immediately. As you build up to having a larger reserve, you can have a portion of it invested in (principal protected) money market instruments that can be withdrawn between 3 to 6 months as necessary.
Money you allocate as short term assets should be secure investments with fixed returns that can cover moderately sized one time expenses within the year. This can range from buying a new car to financing a renovation project to saving up for a vacation or any other significant purchase. Your short term assets should be liquid enough that you can withdraw it when you incur that expense and where the principal is not at risk.
These are assets that carry a significant amount of and range of risks, but are otherwise fairly liquid. Although transaction costs and time it takes liquidate is not a barrier, the sale of these assets can result in realizing positions with gains or losses that have implications on your tax bills due to the capital gains.
Ideally you want to be able hold these risky assets indefinitely or until there is another investment opportunity that you can take advantage of. You can also hold onto assets lower on the risk spectrum for large anticipated expenditures within 1 to 5 years, where risk free assets just don't generate enough return. An example would be money that is being saved towards the down payment of a new home.
Illiquid assets are generally long term assets that either serve a very specific purpose or generally you don't want to be touching for a very long time such as until you reach retirement. Many of these assets are extremely difficult to sell as there are very limited number of buyers and high transaction costs.
There will be instances where you can liquidate some of the investments that fit in this category in order to capitalize on other opportunities or major life events. As an example, if you are upgrading your home or moving to a new country. If these events are anticipated, be sure to have a plan in order to meet your liquidity needs.
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