The investing trinity: risk, liquidity, and return

Investing can seem complicated, but it boils down to three basic principles. 

Issei Kato/Reuters/File
A money changer shows some one-hundred U.S. dollar bills at an exchange booth in Tokyo. According to Hamm, understanding investing starts with understanding risk, return, and available assets.

Every investment you make requires you to balance three different factors.

The first factor is risk. How likely is it that you’re going to get the return you expect over the next year, or the next five years? Generally, lower risk is better.

The second factor is liquidity. How easy is it for you to get money out of that investment? The easier it is, the greater that investment’s liquidity. Generally, higher liquidity is better.

The third factor is return. How much do you expect to earn off of your investment over the next year? This is, of course, heavily tied into risk. Generally, higher returns are better.

Everything you invest in is going to require a sacrifice in one of these areas.

If you want high liquidity and low risk, you’re going to have a low return. You’re probably going to be putting your money into something like a savings account.

If you want low risk and high return, you’re going to have to give up liquidity. You’re probably going to be putting your money into something like real estate.

If you want high liquidity and high return, you’re going to have to take on some significant risk. You’re probably going to be putting your money into something like stocks.

There are different life situations that call on different investment options.

For example, if you want to have an emergency fund that will help you get through painful situations in your life without having to dive into debt or touch your retirement, you’re looking at something that’s high liquidity and low risk, which means you’ll have to accept a low return. Thus, it makes sense to keep an emergency fund in a savings account.

If you want to buy something and sit on that investment for a very long period while it earns you a fairly steady income, you’re going to want something with a low risk and a high return, which means you’ll have to sacrifice some liquidity. Thus, it makes sense for people to invest in rental properties to generate a steady income.

On the other hand, if you want to be able to invest in something that provides a great return, but also want the freedom to jump out of that investment quickly if something in your life changes or if something about that investment changes, you’re going to need something with high liquidity and a high return, which means you’re going to be adding risk to the mix. For many people, it makes sense to invest in stocks for the ease of rebalancing and selling them off.

These descriptions are very broad strokes, of course. Different people may have different opinions on how to specifically invest and so on.

The key thing to remember here is that your life is in the lead. You make investments based on what you actually need in your life above all else. The situation you’re in and what you need out of the investment will lead you to what you should be doing with your money.

Yes, it takes research and time, and yes, you’ll sometimes find contrasting viewpoints, but without a plan for your life before you invest, you’re likely to make a giant mistake, one that will cause you to have your money locked up tight when you need it or be facing a severe loss when you least expect it or be facing very small growth over a long period.

Figure out your life before you figure out your investments. If you know your goals first, the right investment becomes much more clear.

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