A:

Liquid assets, such as cash or highly marketable securities, tend to offer lower returns than illiquid assets. This leaves the liquid-account owners vulnerable to two primary types of risk: purchasing power risk and opportunity costs. Other risks might be present or absent depending on the type of liquid asset.

Types of Liquid Assets

In modern market economies, cash is the most liquid asset. An asset's liquidity is based on its convertibility to cash; a savings account deposit is very liquid because it can easily be converted into cash. Other liquid assets include highly marketable securities, certificates of deposit, or CDs, and tax refunds. Illiquid assets range from long-term government bonds to real estate or collectible art.

Purchasing Power Risk

Liquid assets are often on the losing end of a time value struggle against inflation. When the rate of inflation outpaces the balance on a liquid account, the purchasing power of the balance declines. The chance of relative loss due to inflation is known as purchasing power risk.

For a simple example, consider a checking account that generates no interest. An individual keeps $1,000 in his checking account for a year; the same number of dollars are on his statement balance on Dec. 31 as there were for the preceding Jan 1.

If the rate of inflation for that year was 5%, the real purchasing power of the account declined from $1,000 on Jan. 1 to $950 on Dec. 31. Even though no loss of principal occurred, the individual's assets became less valuable.

Opportunity Cost

Economists are quick to point out that the real cost of any activity is the next-best alternative. In other words, the real cost of spending $1,000 on a new TV is whatever else that $1,000 might have accomplished. This concept is called "opportunity cost." The risk assumed by every liquid account holder is that a better opportunity exists elsewhere.

Consider the individual with $1,000 in the checking account. He might have instead purchased $1,000 worth of a technology stock or reduced his future interest payable by paying down the principal balance on a debt account.

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