The magic triangle of investing
In articles on financial topics, reference is often made to the “magic triangle of investing”. What is it and what does it mean for private investors? In the following article you will learn the most important information.
The “magic triangle of investment” is a term that describes the interaction between the three key factors of “yield” (return), “security” and “liquidity” (availability) in financial investments. The core message of the “magic triangle” is: Every investment requires compromises because all factors can never be realized optimally at the same time.
Usually this concept is visualized with the help of a triangle. Its key points are the factors that are considered desirable in a financial investment.
1. factor return
The “yield” describes the ratio of the annual return to the capital employed. A return of, for example, 5% p.a. means that an investor receives an average of 5% of his invested money per year (per annum) as a return, and this over the entire term of the investment.
The return can be achieved through interest or dividend income, but also through possible increases in the value of a tangible asset or security.
For some investments, returns are fixed; for others, they fluctuate over time depending on a variety of factors. In general, however, there is always the possibility that calculated returns cannot be achieved due to unforeseen circumstances. It is therefore more correct to speak of “return opportunities” in this context – because the actual return on an investment can only be determined in retrospect.
Factor 2: Safety
The “safety” of an investment refers to the probability that the investor will get back his or her deposit. It is the flip side of the risk of an investment.
In practice, every investment involves a risk of loss, because banks and governments can also become insolvent. However, the likelihood of losses or even defaults varies greatly between certain types of investments, which is why certain investments are considered “safer.”
The risk of an investment consists of two components: Probability of occurrence and amount of loss.
For example, it is likely that a stock portfolio will lose value during certain phases. Therefore, shares are generally considered to be riskier. If the portfolio is broadly diversified, there is usually no total loss, and historically losses have evened out over the long term.
In the event of a crisis in the banking system, it is possible that investors will lose their bank deposits completely due to a flood of bank insolvencies and that the current deposit insurance systems will no longer be able to compensate for the losses. The potential loss is therefore high, but the probability of occurrence is generally considered so low that overnight and time deposits are considered “safe.”
3rd factor: liquidity
The term “liquidity” refers to the availability of the invested amount.
How long do investors have to wait to dispose of their deposit? Can they sell them before maturity, if necessary, and if so, what is the cost of doing so? Is there a sufficiently large market for the sale of the investment, or must the seller expect markdowns because demand for the investment product in question is generally low?
The faster, easier and more convenient an investment can be liquidated or sold, the more liquid it is.
Now is the ideal window of opportunity to invest in bonds. Corporate bonds currently offer yields in excess of 7.10% p.a.
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The conflict of the magic triangle
The rule of thumb behind the triangle says: The three factors are in tension with each other when it comes to investing money. If the investor attaches particular importance to one factor, he must accept cutbacks in the other two factors. In practice, this is reflected as follows: Cash investments with high (i.e. daily) availability usually only yield returns below the inflation rate. Offers with high potential returns usually have a corresponding risk that the projected return will not be achieved or that losses may even be incurred. Although high-yield financial products are regularly described as “safe,” this promise often turns out to be dubious. If you want to take advantage of the maximum return opportunities offered by many financial investments, you sometimes have to consciously forego liquidity. Stocks, for example, can be sold in the short term, but investors can potentially make higher profits if they ride out “lean periods” in the stock market and do not sell during them. In particular, the return and the security of an investment are in tension with each other, because a high return is usually a premium for the risk borne by the investor. (However, the opposite is not necessarily true – a low rate of return does not always mean a high level of security). But what about investments that promise high security, constant liquidity and first-class returns? History has repeatedly shown: such offers are potentially suspicious. There is a risk that risks will not be adequately disclosed. The conclusion from the above considerations: Financial investments are always associated with compromises. The magic triangle is a good tool for visualizing these limitations. If you would like to discuss further thoughts and views on this topic we invite you to send us a conversation request via the contact form .