Updated: Nov 17
Author: Lenka Dzadonova
Date of Publication: 27/11/2022
The ideal investment instrument consists of the highest return, lowest risk, and highest liquidity.
Risk and uncertainty are an integral part of investment projects and are an important component of investment decision-making. In fact, the connection of return, risk and liquidity represents the magic triangle of investing. More precisely, their combination is the result of trying to achieve the best result on one vertex, which results in a loss on another vertex. This is because the best result on all three sides of the triangle cannot be achieved simultaneously.
This triangle is the basic principle of how investing works. It is also known as the "alpha and omega" of investing. The important thing to remember here is that risk, return and liquidity should be taken into account in every investment in the financial market.
Elements of the magic triangle of investing
Return plays a big influence on investors because it influences their decision to buy a given asset or not. Under income, it includes all earnings of an investment, from the moment someone puts funds into it until the last possible income from the investment. Most investors seek to maximize return, given the potential risk and liquidity. However, investment return isn’t guaranteed in most stocks. It is also necessary to distinguish between historical and expected returns.
The term liquidity refers to the speed with which we are able to exchange our investments back into cash at the lowest possible transaction costs. However, the degree of liquidity depends mainly on the financial instrument itself and the nature of the market. In fact, it is reasonable to know the degree of liquidity, especially when investing. Investors look for goods that are high on liquidity. That way, if there is a sudden price reduction, they can sell the goods before the prices hit the bottom.
For some types of asset, their liquidity is determined by contractual conditions such as the period of deposit in term deposits. Yet, with most financial instruments, the degree of liquidity is conditioned by their demand and supply.
In addition, there is an opinion that the rate of return corresponds to the risk. Different instruments differ in their degrees of liquidity in different markets. Highly liquid are foreign exchange markets, financial derivatives markets, and government bonds.
For example, the most liquid assets are shares. These can be easily converted into cash on the stock market without any major losses. On the other hand, the least liquid assets appear to be those in real estates. These assets have a minimal, close to zero, liquidity. At the same time, however, their liquidity can increase based on demand and the profitability of the object or location.
Therefore, every investor should consider the composition of assets with different liquidity levels when compiling an investment portfolio.
Risk is synonymous with uncertainty related to expected returns. In other words, it is possible that the actual return will be different from the investor’s expected return. In addition, risk represents a quantity that is difficult to quantify. This is because it is influenced by several factors or their combination.
Anyone who wants to invest should determine the maximum level of risk that they are willing to bear. Since there is no such thing as the one perfect investment, the logical conclusion is: don't put all your available capital into the same one investment. Diversification is key here. Those who combine several types of investment spread their risk and fulfill each of the criteria of the magic triangle.