Investing Trinity: Understanding Risk, Returns & Liquidity

risk returns liquidity investing trinity

If you speak to enough investors or lurk on investment forums long enough, you’ll definitely have come across the phrase:

“No risk, no reward”

Same as no pain, no gain, it does seem rather logical, doesn’t it? Take on more risk, and potentially get rewarded with more returns.

Not quite.

We’re missing our final element, liquidity. That is what completes the Investing Trinity.

Risk

Risk refers to the probability that the return from your investment differs from your expectation. This is often understood as the probability of losing part or all of your money in an investment. In general, lower risk is desired.

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Low risk includes investments such as bonds and fixed deposits while high risk investments include instruments such as stocks.

Returns

Returns refer to the gains or losses made from the money placed in an investment over a period of time. If you purchased a share at $10 and sold it at $11, that’s $1 in returns! Needless to say, higher returns are generally better than lower returns.

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Generally, investments such as fixed deposits and money market funds yield low returns while investments such as properties can yield higher returns.

Liquidity

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Liquidity refers to how easy it is to turn an asset into cash. Naturally, this would also mean that cash is the most liquid, since it is already cash, whereas things like properties are less liquid because it would take months to turn your property back into cash. More liquid investments are generally desired over less liquid ones.

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Investing Trinity

The Investing Trinity refers to the fact that there is a certain trade off between these three elements of Risk, Return and Liquidity in every investment. This means often we are able to find an investment that fits into the desired category for two of the elements but not the other. For example, stocks would be high risk, high liquidity and high returns.

If you hear of an investment that is low risk, high returns and high liquidity, chances are it’s too good to be true and you’re talking to an internet scammer!

risk returns liquidity trinity
The Investing Trinity: Risk, Returns & Liquidity

Well then, let us take a look at some common investments to better understand this. We’ve already touched on some of them when discussing the three elements but here we bring it all together. Granted, this is a little bit of an oversimplification of investments as these elements exist on a spectrum and often it’s not simple to group these investments into 3 simple bands for each of the elements.

trinity table

* Yes, it is true that a lot of people lost money during the housing bubble in 2007-08, but that was largely because many of them were overleveraged. Had they purchased properties that were within their means, they would have mostly made good returns over the last 12 years.

What do I do with this information though?

Understanding the Investing Trinity is important because different instruments should be used to achieve different things. It is important to understand that low risk is not always good and high returns are not always worth it.

For example, if you’re looking to save up for a BTO or your upcoming wedding, stocks are not a good pick, because of the high risk involved, which may wipe out a significant portion of the amount you saved up. Instead, you might want to try Fixed Deposits or High Yield Savings Accounts instead which may only yield between 1-2% but have close to no risk and allow you to withdraw quickly.

Likewise for emergency funds, where you may need the money on short notice, high liquidity and low risk is desired over high returns.

However, if you’re trying to build long term wealth, a High Yield Savings Account isn’t going to get you far. Even with compounding, 2% annually won’t make you much, especially after taking into account inflation, which has been around 0.5% for the last few years, you’re back almost to square 1. For long term growth, you’ll be better off choosing something like stocks or property investing, which offer much higher returns albeit with much higher risk or lower liquidity.

Opportunity Cost and Cutting Loss

At the end of the day, it is important to know where you put your money and why you put them there. Each investment is created for a purpose and you must understand the purpose of each instrument before using it. After all, putting 100% of your savings into stocks is probably not the wisest thing to do and likewise, putting 100% of your savings in a High Yield Savings Account probably is even worse.

Like a general in battle, you must understand the tools at your disposal and you will be able to utilise them well to execute your financial plans.

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