Illiquid assets are those assets which are not sold quickly as a result of lack in the interested buyers or established trading market.
Financial pundits have often stated that the most important thing in business is liquidity. But what is liquidity? Let us deep dive- What Is Liquidity? As the term suggests, liquidity is the quality of being liquid or flowing free like water. In the business sense, liquidity refers to the amount of money that is easily accessible for spending and investment. As deciphered, the concept related to quick access to cash. Some experts even regard liquidity to be the amount of cash and cash equivalents. Another way to look at the concept is this- both individuals and businesses hold assets or security. Liquidity refers to the ease with which these may be bought or sold in the market for conversion into cash. It involves the trade-off between the price at which a particular asset can be bought, and how quickly it can be sold. Getting the basics- In a liquid market, the trade-off is mild, which means that assets can be sold quickly without having to accept a significantly lower price. On the contrary, in a comparatively illiquid market, an asset is required to be discounted to sell quickly. Why Is Liquidity Important? The answer to the above is simple- Liquidity may be the most effective silver lining when one encounters the need for urgent cash, which can occur anytime. Liquidity is the ability to get one’s money whenever one needs it. It can be looked upon as an emergency savings account or cash lying with someone that can be easily accessed in case of any unforeseen happening or any financial setback. Besides, liquidity plays a vital role as it allows individuals and businesses to seize opportunities. This is because if one has cash and easy access to fund, it is easier to seize any opportunity that comes along. Financial experts often stress upon the importance of liquidity when one is planning investments. It is crucial to factor liquidity in financial plans to ensure that one has secured its long-term as well as short-term needs. This further should ensure that one does not utilize/ incur a loss to discount their long-term investments when in need. Discussing the importance of liquidity from an investment perspective- It plays a critical role in balancing one’s portfolio with trade-offs between risk and return. It may help accelerate transactions, as having liquid funds reduces the time-lapse from when the asset is put for sale and by the time one finds a buyer. Liquid funds are known to retain their value when they exchange hands, unlike many illiquid funds. ALSO READ: What Is Market Liquidity? Features Of A Liquid Asset A liquid asset may have some or all of the following features- What Are The Measures Of Liquidity? There are two main measures of liquidity- Market Liquidity- Indicates market situation where assets may be purchased or sold off quickly. This type of liquidity is particularly evident in the case of real estate, the stock market or financial market. Markets for real estate are typically far less liquid than stock markets. The shares traded on stock exchanges are usually found to be liquid due to a large number of buyer and seller available, which leads to easy conversion to cash. Accounting Liquidity- The comfort with which a business or an individual can meet financial obligations through liquid assets is accounting liquidity. It requires a comparison of the liquid assets held by the business or an individual to that of current liabilities in a financial year. The current ratio and cash ratio measure this. What Are The Different Liquidity Ratios? Businesses and individuals use liquidity ratios to evaluate their liquidity. These ratios help them to measure their financial health. The three most important ratios include the current ratio, quick ratio, and cash ratio. Let us look at a few interesting facts about the above ratios- The current ratio is believed to be the simplest and less stringent. Quick Ratio is also referred to as the acid-test ratio. The cash ratio is believed to be the most exacting of the liquidity ratios. More than the other two ratios, it assesses the business’ or individual’s ability to stay solvent in the case of an emergency. Liquidity Management At any point in time, and especially in turbulent times, a Company may be asked to demonstrate its ability to remain viable and liquid. This is where liquidity management comes into the picture. Liquidity management describes a company’s ability to meet financial obligations via cash flow, funding activities, and capital management. It is impacted by revenue and cost generating activities, capital and dividend plans, and tax strategies- making it a challenging concept. Liquidity management is strongly associated to broader market, credit and general business risks. So how is liquidity managed? For starters, monitoring the liquidity ratio is key to keep a regular grasp of the company’s liquidity risk. To do so, most liquid assets are compared with short term liabilities or near-term debt obligations. Other techniques comprise- Receivables management– the stringent methodology to make sure that clients and customers maintain payments in a timely and orderly fashion. Netting portfolio management techniques- which allows the company to consolidate debt obligations. Herein, the company nets third-party invoices. It is usually applied when the company has several outstanding invoices from the same vendor and agree on terms by which the total outstanding amount will be paid on a certain date. By practising this approach, a single payment suffices rather than a number of instances to unsettle cash reserves. Understanding Liquidity Glut & Liquidity Trap While walking through the concept of liquidity, understanding liquidity glut & liquidity trap is essential. Liquidity Glut—when savings exceeds the desired investment As understood, high liquidity means a lot of capital. But what happens when there is too much capital and too few investments? A liquidity glut. This is a situation wherein savings exceeds the desired investment. Often a liquidity glut may lead to inflation. Cheap money pursues lesser profitable investments, and prices of those assets increases. Liquidity Trap- monetary policy becomes ineffective This occurs when the Government’s monetary policy does not create more capital; for example, post a recession. In this situation, interest rates are extremely low, whereas savings are high, making monetary policy ineffective. Consumers ideally prefer to save rather than invest in higher-yielding bonds or other investments. Raising interest rates is one of the most effective ways to get out of a liquidity trap, the other being increasing government spending, which may in turn aid unemployment too.
Trading is an economic activity which involves buying and selling of goods and services in exchange for money. In the financial market, trading is the same concept; the only difference is it deals with securities, currency, commodity etc. What is the Significance of Paper Trading for Beginners? To trade successfully on a consistent basis is not everyone’s cup of tea. Often at times, new traders end up blowing up their entire capital quite early. This happens due to a lot of reasons which are difficult to rectify early on and at once. These hindrances could be lack of knowledge, lack of patience, no prior experience and inability to control the two primary emotions, fear and greed which eventually drive the market etc. To counter these issues gradually, paper trading is often recommended, especially at the very beginning stage. What Do We Mean by Paper Trading? Paper trading, as the name suggests, is a dummy form of trading in which the trades are not executed on an exchange but are written on a paper, which allows investors/traders to hone their trading skills without putting a penny at risk. These trading skills could include the timings of entries and exits, position-sizing, risk management strategies etc. There is no capital at risk as the trades are only written on paper. But the simulation of these trades is done in accordance with the actual price that is being quoted on the exchange. With all the hypothetical positions, portfolios and risk but with real price fluctuation, an aspiring trader can learn a lot of things which a mere theoretical book cannot teach. Like any other skill in life, one needs to practice trading in order to improve upon the skill. Paper-trading solves this purpose of practice without putting actual money at risk. What is the Purpose of Virtual Trading – Technology based paper trading? With the constant upgradation in technology, nowadays there is an improved version of paper trading called virtual trading. The underlying concept remains the same, to help new traders to practice and improve their trading skills in a simulated environment but with the integration of technology. In conventional paper trading, the trader continually needs to keep updating prices manually. This could be a tedious task if the frequency of trades is high, especially for intraday trading. Also, a manual log of all the trades needs to be created if the trader wants to look back at the past few trades for any analysis purposes. Another drawback shows up in the errors. While manually updating prices or another field like net P&L etc. there is a good chance of making a few errors which could lead to the false representation of the P&L. All these issues are being taken care by technology-based paper trading where all the data feeds are being updated automatically, and live prices are updated. Some of these virtual trading platforms are free while others with advanced features like graphical representation of data or calculation of some advanced metrics etc. can be paid once. What are the Advantages of Paper trading? A few of the advantages of paper trading for which it is considered to be one of the best ways to learn to trade in the beginning phase are; Testing of a strategy Before deploying a specific strategy, it is always advisable to first test it. Paper trading helps the trader to test his strategy within a simulated condition which is identical to the live market conditions. This helps to ensure whether the strategy would work or not in the live market. Also, if the strategy fails to work, then the loss will only be virtual as no real money is involved. No additional infrastructure required Virtual trading platforms are quite easily available nowadays. Even some brokers have started to offer this service to their clients. Most of the platforms are free and only requires a sign up to start doing paper trading. No legal documents are required to open a virtual trading account unlike a live trading account. No stress Stress is something which even the best of the traders goes through, especially during the period of losses. As with paper trading, no real money is involved; hence high stress is generally not there. Confidence Boost After a few months, once the trader gets the hang of his strategy, understands the shortcomings of his methodology and strengths and also gains relevant experience, he can confidently start to trade with the real money in the live market. What are the Disadvantages of Paper Trading? Despite being such a helpful and effective way to learn to trade, it has some drawbacks too, which must be taken into consideration while paper trading. Ignores some associated cost While paper trading helps to keep track of P&L of individual positions but there are some exclusions from it like brokerage and slippages. Slippage is the difference between the bid and ask price which can reduce the P&L by a meaningful amount, especially when the market is illiquid. As different brokers charge different brokerages, it is not possible to incorporate it in a trading platform, although it can be written manually. Ignores emotions and psychology If topmost traders of the world were asked to define the single biggest factor which sets a successful trader apart from the crowd, psychology would be heard from most of them. Trading psychology alone can turn a good trading strategy or a specific analysis into a bad one, the sole cause of which is the involvement of money. Whenever money is at risk in any decision, most of the time, the emotions take over and hamper the ability to think clearly. These two emotions are Greed and Fear. As there is no money involved in paper trading, these emotions are generally muted and may go onto a completely different level while trading live with real money. This may create a humongous difference between the performance in both the scenarios. Is there any alternative to paper trading? To eliminate the drawbacks of paper trading, some traders start directly with the live trading with real money but with a very less quantity. The quantity is so small that the P&L fluctuation is almost meaningless. This is as good as paper trading but also eliminates the drawbacks of paper trading as trades are executed live on an exchange which accounts for brokerage and slippages and gives realistic P&L figures. Also, money is involved, which helps to practice emotional stability and psychological resilience.
What is Annuity & its fundamentals? Annuity, a contract meant for long term duration, is issued & sold by a life insurance company. The insurance company makes the payment in a fixed stream to retirees upon annuitization, which is generally an income to the latter. The annuities are designed to underpin the growth of retirement income and are funded by individuals. In case of a deferred annuity, where payments begin after a certain duration, there is an accumulation phase which is the time period when an annuity is being accumulated before the fund payouts to the individuals begin. When the payments start, the contract is said to have entered an annuitization phase. In case of an immediate annuity, payments begin immediately in the annuitization phase, and there is no accumulation phase. The life insurance company after accumulating funds from individuals generally invests in mutual funds to get profit from their investments. What is the Purpose of Buying Annuities? As a part of retirement income planning, the annuities are relied upon to get a regular income through a steady cash flow in the retirement phase. The investors can take the payments either as a lump-sum amount or get paid periodically. The payment to the annuitant is done either for a fixed period or for the annuitant's remaining lifetime. On the other hand, making the corpus of fund for retirement is not easy, as one has to find out how much an individual needs to save to retire. This is where the real financial planning begins. There are a number of retirement savings options available to an individual, tailored to specific needs. For example, investment can be made through the employer in the form of an annuity or super funds or pension plan. Meanwhile, some market players in favor of income strategy also consider exposure to dividend stocks for beefing retirement investment portfolio. What is the difference between Annuities and Pension? While both annuities and pension are common sources of retirement income, it is important to understand the difference between the two. Though annuities are purchased from insurance companies via the signing of the contract, the pension is generally a kind of retirement account offered by companies to their employees. Individuals buy an annuity scheme from life insurance companies to get a guaranteed regular/lump sum income after retirement, whereas people save from the amount earned to make a pension pot throughout the life when they are earning. While pension benefits are availed post the retirement, financial benefits of annuities do not necessarily require the person to retire. ALSO READ: Retire from Work, Not From Life: Superannuation And Age Pension What is the difference between Annuities and Insurance? While both annuities and insurance plans are essential components of long-term financial planning, some differences between the two deserve closer attention. Notably, annuities can be purchased without a medical need, unlike insurance. Looking a payment flows, annuities dole out funds to the owner when the annuitization period begins as per the contract. While, insurance schemes provide income streams to dependent in case of the owner’s death, unless the policy is surrendered. What are the different types of Annuities? There are various types of annuities, and the exact payment structure of each individual will depend upon the terms that the individual had agreed with the insurance company. Annuities can be structured into different kinds of instruments, that includes fixed, variable & indexed with the options of immediate or deferred income, that gives the investors flexibility to get their payments as annuities in different forms. Fixed annuity provides the guarantee of a minimum rate of interest on the money invested by an individual and also offers a fixed number of payments that will be received from the insurance company. Variable annuity gives the individuals an option to invest the money in different types of securities as the mutual funds do. The payments an individual will receive in the form of annuities will depend on the performance of the funds. Indexed annuity combines the benefits of both fixed and variable products. The returns on investment an individual will get from an indexed annuity are not dependent on individual’s investment decision but will depend on the performance of stock market indices like the S&P 500, where the fund manager invests in the stocks of the index in the same weightage. An investor in all the three annuity types, has an option of choosing an immediate annuity or a deferred annuity. In an immediate annuity, the individuals deposit the insurance company with a lump sum and can immediately start receiving the annuities. In a deferred annuity, the individuals pay a lump sum or a series of payments but will not start getting payouts as annuities until a specified period. This gives the individual’s money an opportunity to perform and either earn interest or appreciate, as for a variable annuity. What are the Benefits vs Risks of Investing in Annuities? An annuity is considered to be a good option as it offers regular payments, tax benefits and a potential death benefit. The most basic feature of an annuity is the individual gets an opportunity to tap regular payments in the form of supplemental income from an insurance company during the retirement. This will help the individuals that have not saved enough to cover their normal expenses. Further, the money that individuals contribute to an annuity is tax-deferred, which means the individuals do not need to pay taxes on the money until the individual starts receiving the payments. Annuities somewhat guarantee returns in terms of safeguarding retirement related financial requirements. Meanwhile, there is a certain level of risk involved when individuals invest their money. The individuals get fixed annuities guarantee on a certain percentage of the individual’s principal (original) investment, which is generally quite low. Moreover, variable annuities carry more risks because of the probability for an individual to actually lose the money, depending on the fund’s performance. However, variable annuities offer an extra benefit, which is a death benefit. Besides, the annuities have illiquid nature. Once the individual has contributed the money to fund an annuity, he cannot get it back or even pass it on to a beneficiary. It could only be possible if the individual has opted for another annuity plan, however, this could involve fees attached to it. Further, the benefits will disappear when an individual die. Besides, annuities generally involve high fees like administrative fees, mortality and expense fees associated with annuities, which makes the annuity products among the most expensive investment products available in the market. Insurance companies charge these fees, in order to cover the costs and risks of insuring the individual’s money. What do we understand by Death Benefit Associated with Variable Annuities? A death benefit is a payment made by the insurance company to a beneficiary when an individual who invests principally dies. The death benefit for a basic variable annuity is generally equal to the amount that the individual had contributed to the annuity. It will not depend upon the performance of the securities of the annuity’s fund. There are also variable annuities with enhanced death benefits, in which the insurance company records the value of the individual annuity’s investments each year on the annuity’s start date. In the case an individual dies, then the insurance company pays a death benefit equivalent to the highest recorded value of the annuity. For example, suppose an individual has entered into an annuity contract of total value $50,000 and on the anniversary of the annuity’s start date, the individual’s investments have increased to $75,000. The individual’s death benefit would then be of total value of $75,000, even if the value of the investments has fallen for the rest of your life. What are the different terms associated with Annuities? The annuity contracts have surrender charges which apply to both variable and fixed annuities. Surrender fees are generally high and require to be given for an extended period of time. A surrender charge is incurred when an individual goes for more withdrawals than actually allotted. The insurance company has the power to limit withdrawals primarily during the early years of the contract. Some annuities also have additional riders attached that are availed by giving an extra fee. A rider provides a guarantee which is optional. For instance, adding death benefits to an individual’s contract requires a death benefit rider. Rider fees will vary across individuals, but they can be of higher costs (up to 50% of the value of the in account). Moreover, the deposits into annuity contracts are generally locked up for a certain duration, which is known as the surrender period. The annuitant would incur a penalty if all or part of that money within this period gets touched. These surrender periods can be of a time period of two to more than 10 years, which will depend on the particular product. Surrender fees can be of 10% or even more and the penalty generally falls annually over the surrender period.
Retired CEO of the Vanguard Group, John Bogle rightly stated- His logic is simple, yet solid- investing is about owning businesses and reaping the rewards of their growth. Now, these rewards come in the form of business growth as well as dividends. In this backdrop, let us walk through the interesting concept of Dividend Reinvestment Plan. Before that, we encourage you to brush up a few dividend basics HERE: DIVIDEND BASICS. What Is Dividend Reinvestment Plan (DRP)? A DRP is a formal program that is offered by a publicly-traded company to its existing shareholders. As per the program, investors are provided with the opportunity to reinvest their cash dividends into additional shares of the underlying stock on the dividend payment date. Breaking this down further- when dividends are paid, they are received by shareholders as a direct deposit in their bank accounts or as a check. DRPs give stock market enthusiasts the option of reinvesting the amount of a declared dividend into additional shares, bought directly from the same company. In a nutshell, in a DRP, the dividend declared is not paid but re-invested to buy additional security units. Thus, an investor who has opted for the DRP is bound to see a higher number of units allocated to him, periodically. ALSO READ: All About Smart Dividend Investing What Are the Types Of DRP? There are three common types of DRPs- Why Is DRP Significant? There are numerous benefits of buying shares through a DRP. These can be reaped by the company issuing the shares as well as the shareholders. Significance for Investors: A DRP is a great way for shareholders to accumulate more shares. There are no commissions attached to a DRP, and there prevails the possibility of a price discount. Consequently, the cost basis for purchasing the shares through a DRP can be considerably lower, compared to buying them from the open market. Further, investors can also buy fractional shares (a portion of an equity stock that is less than one full share). In the long term, the effect of automatic reinvestment on the compounding of returns is an added advantage. The below flow chart clarifies this process- Significance for the Company: Companies that pay dividend benefit from DRPs in the following ways- When shares are bought from the company for a DRP, there is creation of more capital for the company to use. Shareholders who partake in a DRP are less likely to sell their shares when the stock market drops. The focus ideally remains on long-term investing and long-term growth. Besides, DRP-purchased shares can only be redeemed via the company and are not as liquid as shares purchased on the open market. GOOD READ: Why is a Dividend Stock Investing Strategy Important For An Income Stream? Are There Any Drawbacks Associated with DRP? Like any other instrument and activity in the share market, DRPs have both an upside and a downside. Few disadvantages of DRP are- As the company issues more shares to shareholders, more shares tend to become outstanding in the market. Consequently, shareholders that do not participate in the DRP may see their ownership base diluted. Shares acquired through DRPs are not exempted from taxes as they are deemed to be an income for the shareholder. Tax reporting (record of a transaction, cost base, capital gains/losses) is an added responsibility for DRP participants, which can be a time-consuming process. As the investor acquires more shares via a DRP, his/ her portfolio will naturally be heavily exposed to the company. This could curtail diversification and necessitate periodic rebalances to the investment Should One Elect For DRP? Now, the main question that arises is- should DRP be chosen? In today’s evolving times, there are numerous investment opportunities for an investor in the financial market- mutual funds, banks, shares, bonds, gold, real estate etc., depending upon the risk appetite and investment duration. Nonetheless, it is a well-accepted fact not all investment modes can be suitable for every investor. DRPs can be opted if shareholders wish to save on transaction costs while purchasing shares. Besides, those with a long-term perspective can choose a DRP to receive compounding returns (explained in the figure above). On the flip side, some market experts believe that DRPs are not always a feasible option, especially in the case of equity or a balance scheme. This is because as the value of investment under the growth option and the dividend reinvestment option remains the same at the end. GUIDE CHECK: Guide to investing in Dividend Stocks Dividend Payout Plan vs Growth Plan Vs DRP We will understand this comparison in the backdrop of mutual funds, which provide a choice of three plans- Growth Plans, Dividend Payout Plans and DRPs. GOOD READ: Dividend Yield or Dividend Growth! Bottomline The consensus opines that for long term financial planning, growth plans are the best. The ones on a hunt for a source of regular income can prefer a dividend payout plan. DRPs, on the other hand, are an automatic reinvestment arrangement. They encourage long-term investment instead of active trading. Besides, they tend to have a stabilising influence on stock prices. An investor can assess his/ her investing motive, style, and risk appetite to select the plan of his/ her choice. DON’T MISS: 5 Tips for finding sustainable dividend yield stocks