I recently read a definition of liquidity risk that called it “the inability to have assets available to financially support unanticipated cash flow needs.” You could translate that as: “Stuff happens and you need to have enough cash to cover that stuff when it happens.” The “stuff” is an unusual, nonrecurring expense like a big car repair or dentist bill.
Liquidity risk can be especially dangerous if you are retired and living on your investments. You don’t want to be forced to sell your investments in a disorganized way because you have to cover an emergency.
I strongly advise you mitigate liquidity risk by setting aside an emergency fund and that you think of that fund like the foundation of a house: Your financial strength is dependent upon the amount of cash you have available to cover emergencies. Yes, I do mean cash. And yes, that cash in the bank won’t give you a good rate of return. Consider that opportunity cost your insurance premium.
How much cash should you have in your emergency fund? If you have a reliable source of income (wages, a pension, real estate income, etc.), I suggest you set aside 3 to 6 months of your cost of living in cash. For example, if your cost of living is $4,000 a month, an emergency fund of $12,000 to $24,000 in cash should cover most nonrecurring, unexpected expenses.
If you don’t have a regular source of income and rely heavily on your investments to cover your cost of living, I suggest you have 1 to 2 years of your cost of living in a cash emergency fund. So if your cost of living were $4,000 a month, you’d set aside $48,000 to $100,000. It’s a lot of money, but I believe that if you want to protect yourself against liquidity risk, an emergency fund is not an option. It’s a necessity.