Define liquidity risk and how it can be mitigated in a financial plan.

• A. The risk that assets cannot be quickly converted to cash without significant loss; mitigated by emergency funds and holding liquid assets.
• B. The risk that assets can be liquidated quickly with no loss.
• C. The risk of stock price fluctuations.
• D. The risk of inflation eroding purchasing power.

Answer: (B)

Liquidity risk is the risk you won’t be able to convert assets into cash quickly enough to meet short-term obligations without taking a meaningful price concession. In a financial plan, this is mitigated by building a cash buffer (an emergency fund) and keeping a portion of the portfolio in liquid assets or instruments that can be sold with little or no loss when cash is needed. Having access to reliable credit or lines of credit and aligning near-term cash needs with liquid resources also helps reduce this risk. The option describing assets that can be liquidated quickly with no loss isn’t a risk at all, so it doesn’t define liquidity risk. It’s addressing the situation of perfect liquidity, whereas liquidity risk focuses on the potential need to sell quickly and possibly at a discount.