Chapter 17 – Liquidity, Risk, and Return

Investments are measured and evaluated in many different ways. Among the most important characteristics of an investment are its liquidity, riskiness, and return.

Characteristics of Investments

There are three main characteristics of investment assets that you should understand.

1. The rate of return is simply the interest rate at which the investment grows. The higher the rate of return, the higher the amount of interest the amount of interest the investment will produce each year. High rates of return are good because they

2. The level of liquidity of an investment depends on two criteria. First, it must be able to be sold quickly. Second, it must not lose its value when it is sold. The faster you can sell an asset and the more stable it's value, the most liquid it is.

Liquidity is a spectrum. Assets can be highly liquid, somewhat liquid, somewhat illiquid, very illiquid, or anything in between. For example, a checking account is extremely liquid because you can go get the balance in cash on a moment’s notice without any loss of value. A house is very illiquid because selling it for cash can take a very long time, and when you do sell it, you may have to settle for a price that is less than what you paid for it. Stocks are moderately liquid because selling them usually doesn’t take long, but the value you get back is very uncertain.

As a rule of thumb, the more liquid an asset is, the lower the rate of return the investment is expected to produce.

3. All investments are subject to two different kinds of risk.

Investment risk is what most people think of when they think of their investments being "risky". This risk is the chance of losing money you have invested. Some investments have a low chance of losing money. They have low investment risk. Others have a high chance of losing money. They have high investment risk.

Investment risk is two-sided - you can't earn money without taking the chance of losing money as well. This is why investor's have a common saying: no risk, no reward. In general, investments that offer high investment risk are only interesting because they also carry a chance for earning a lot of money. In other words, you can only increase the rate of return you can earn if you also increase your investment risk. No risk, no reward.

The other type of risk is the risk of losing purchasing power (sometimes also called "inflation risk"). Because of inflation, the cost of goods and services increase over time. If your investment has too low of a return, then you will lose purchasing power over time. The result is that your lifestyle may suffer in the long run even though you have money.

Checking accounts have low risk of losing the amount you deposit but have a very high chance of losing purchasing power over time. This means that when you get old you will not be able to buy as much things as you would like.

For the purposes of this book, we will call an investment “risky” when it has high investment risk. The higher the level of this kind of risk, the higher the potential return the investment can provide. The lower this level of risk, the lower the level of return the investment can provide.

Diversification

The key lesson from the investment pyramid is that you don’t want too much of any one type of investment because it exposes you to too much of each kind of risk. But if you don’t want all of one type of investment, then what do you do?

The best way to handle this decision is to consider using diversification. The principle of diversification can be summed up by the phrase “don’t put all your eggs in one basket”. To properly diversify your portfolio takes some work. You need to decide how interested you are in doing the work required for proper diversification. For the items at the very top of the investment pyramid, you should consider very carefully if they are truly necessary. Not a lot of investors have enough risk tolerance to handle investing in these types of investments. Invest in them with caution.

For the investments in the middle of the pyramid, choose wisely what you buy. Consider the mix of bonds and stocks and mutual funds that you want to use. Are you interested in investing in real estate? These investments generally occupy the largest part of most investors portfolios.

Lastly, the investments at the bottom of the pyramid can be helpful at balancing the overall riskiness of your investments. Consider including cash and cash equivalents, cds, money market funds, and mutual bonds in your portfolio when you want to reduce your chances of losing money. Be careful though – these investments also have a high chance of losing purchasing power. Too many investments from the bottom of the pyramid will lower your chance of losing money, but they also steal your ability to earn interest over time!

Keep in mind these key relationships between liquidity, risk, and return as you consider which investments you want to have in your investment portfolio. By balancing your investment needs against the risks and liquidity of the asset you are investing in, you can create an investment portfolio that is effective at meeting your investment goals.

This is an excellent time to watch Lecture 11 from the course pack.

Definitions:

Return: the rate at which the investment grows

Liquidity: able to be converted into cash quickly and not lose its value when it is converted to cash

Investment Risk: the chance of losing the value you have invested

Purchasing Power Risk: the chance that your assets will lose purchasing power over time due to inflation.

Diversification: a risk management technique that mixes a variety of investments within a portfolio