- The return of an investment is only one side of a coin. Not enough to make good decisions.
- You have to study also the risk and the liquidity.
- Most people only ask for the return and don’t understand the risks.
- High return, low risk, and good liquidity? You can choose only two, at most.
- Holding secure investments can also be risky in case of negative interest rates.
What Is the Magic Triangle?
Magic triangle, sometimes also called investing triangle or investing trinity is the “grandfather of all investments.” It gives you a general recipe for the evaluation of your present or future assets. Although it is not a wonder potion or an all-powerful tool. It has some similarities with the following quote. I have heard that as a child already, about health care, car repair, and other services:
clients can have good, fast, or cheap. Pick two, but then the third will be whatever it has to be based on the other two choices. You can have good and fast if you’re willing to spend a lot of money. You can have fast and cheap, but the quality will be poor. You might even be able to get good and cheap if you’re willing to wait a long time. (Source)
The magic triangle of investments works similarly. It has three edges: The return, the risk, and the liquidity of the investments. (Or, profitability, security, and liquidity.) People are searching in the first line only for a good, high investment return. But they forget the risks and the liquidity. (Most people don’t even know what liquidity is.) I can prove that with the chart of Google Trends. Many more people are searching for investment returns or good investments (blue and green, also yellow lines) than for risks (red line). Liquidity is unknown to them. (It was below the purple line on the chart.)
Don’t Overestimate the Return
Studying only the yield of an investment, searching for a good return is one side of the coin. It’s just like you care about how much you will earn, but not at what efforts, what risks. For example, you might get a high-wage job but one year later you may die. Or, of a disease caused by your work or, getting killed in duty. Risk is “exposure to the chance of injury or loss” in the dictionary. In finances, it means the possibility of total or partial loss of your investment. This risk is never zero. That’s why studying investment return is not good enough. But what is liquidity?
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value. In other words: the ease of converting it to cash. (Investopedia)
Why Is Cash So Often the King
Cash is always considered the most liquid asset. That’s because people sometimes say “cash is king”. Real (tangible) assets – like real estate, art pieces, jewelry, oldtimer cars, etc. – are very illiquid. Shares in companies and other working businesses can have different liquidity. Stocks, bonds, other assets on stock exchanges are liquid. Can be sold, “cashed-out” mostly in a couple of days. Other assets, like limited partnership units, shares in private companies are much more difficult to sell.
Some investments are circulating in public but are also illiquid. Like some special investment trusts, real estate funds, hedge funds. The redemption of these investments is subject to a time limit of several months. Imagine that you found the home of your life, you need quickly $20,000 to get the bank loan in a week. But your investment is frozen for months. Or an unexpected misfortune – illness, death, accident – happened in your life. That costs you a lot, but you can’t pay. As a result, extra expenses arise, such as heavy penalties. Lack of liquidity can cause big losses.
Frozen Accounts and Crashed Companies
I say the risk is never zero because also seemingly liquid or secure investments can end in a nightmare. An example is the famous Greek crisis in June-August 2015. Greek stocks, bonds, bank accounts got inaccessible after creditors refused to extend the country’s bailout. Savers queued in front of the bank offices to withdraw their savings. But had to wait more than two months. Even bank accounts, considered by many people as cash, got frozen for this period. (Banks paid only limited amounts to every citizen.) The stock exchange was also closed.
Other examples are stocks of companies like Enron, or Lehman Brothers. Both were originally reputable, huge, strong American holding corporations earlier. Even so, they went bankrupt, and the assets of shareholders and creditors fell to zero or a fraction.
Zero Investment Return Policy
A good investment return means for many people to be able to double their money. Or at least a double-digit annual yield. But this is completely unrealistic. Yet, many cheaters make use of this desire. There are some investments where the liquidity is, in reality, zero or the risk is infinite. For example Ponzi and pyramid schemes, loans to persons with zero trustworthiness… If you gave them your money, you never got it back. (I wrote about the worst investments here: 6 Effective and Proven Ways to Lose Your Money)
Other Interesting Triangles:
- Stocks, bonds and cash – the trinity of classic portfolio elements.
- Earn, save, and invest – three basic tactics to grow your wealth. In the best case, they are applied together and combined. As I wrote here: Which Is Your Best Source of Money? Investing, Saving or Earning?
- Health triangle: Your “total health” refers to three kinds of health — physical health, mental health, and social health. (Source)
- Wealth Triangle: Time, Savings, Rate of Return. (Source)
- Impossible trinity or the trilemma – a concept in central bank policymaking. (Wikipedia.)
You Can Choose Only One or Two
In the beginning, we wrote about services: “clients can have good, fast, or cheap”, but not all the three at the same time. The same happens with investments. Good, high investment return without risk doesn’t exist. Investments with the possibility of high returns are very risky and sometimes illiquid. (Real estate, hedge funds, startup companies, growth stocks.) Something with good liquidity has a low return in general, perhaps also a low risk. (Like bank accounts.) Relatively high return, low risk, but poor liquidity describes some real estate investing forms and private companies.
Sovereign bonds (state debts) are considered as the most conservative and secure assets in the world. But in the last years and in many countries, they also present a risk. Holding secure assets with a negative or low interest rate is also a form of losing money today. Your wealth is worth every month or year less. Because inflation devaluates your investment. You should think in real terms, pretend to reach positive real returns (interests, yields). (Read: Eight Ways How Inflation Threatens Your Income and 13 Ways to Fight It)
Do You Wish to Sleep Well, or to Eat Well?
Eating well, or sleeping well – that is an ancient dilemma of investors. They must choose if they want to take risks for more income, to reach high return. Or they want to sleep untroubled, and the investment return can stay lower. They want to feel secure. Risk and return are tied – the higher the risk, the more return investors can expect. (But the probability of unwanted losses also increases.) The choice is yours – keep learning, or ask your adviser.
OK, you may understand now why you should consider risk and liquidity and not only look for some sort of seemingly good investment return. But how do you measure return, risk, and liquidity? The truth is, you can fill an entire library with books and articles about this topic. Investment professionals are also struggling with the same problem. Check back, we will continue with important topics like this on Agelessfinance.com.
More Important Readings for You About Your Money:
- 6 Effective and Proven Ways to Lose Your Money
- How Works Compound Interest? Learn the Secrets of the Dark Side
- Eight Ways How Inflation Threatens Your Income and 13 Ways to Fight It
- Which Is Your Best Source of Money? Investing, Saving or Earning?
- Is It A Myth? – The Genuine Truth About Passive Income
- Why Do You Need Ageless Finance? Priceless Lessons of Our Ancestors
(Cover photo: Pixabay.com, “stux”, eurocents, slightly altered)
I’m not a certified financial advisor nor a certified financial analyst, accountant nor lawyer. The contents on my site and in my posts are for informational and entertainment purposes and reflecting my collection of data, ideas, opinions. Please, make your proper research, or consult your advisors before making any investment or financial or legal decisions.
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