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Liquidity, risk and trade offs

I can’t even tell you how many times I have explained asset classes and the risk/return relationship! After explaining it many times, I came across a great explanation that relates to anyone and explains it all very well.

Basically, there are 3 asset classes: cash, fixed income and equity. If you think about it, we all have them. We all have cash coming and going from our accounts, we have all borrowed or lent money and we have all owned something.

And here’s how any given household will experience all of these:

Cash is put on deposit at the bank. You can get it any time you like with little to no restrictions – we call this liquidity – and you will likely be making little to no return.

Liquidity is the real benefit here.

The bank will loan this money out as a mortgage, car loan, student loan, business loan, etc. The interest the bank charges is higher than you are being paid on your savings account but they lend it out for a specific period of time and can’t recall that loan – there is no liquidity – until the term is done.

The increased rate of return with liquidity being a known are the benefits here.

What do people who borrow money do with it? They buy houses, cars, educations, build businesses – whatever they want. But the key is that they buy things or build equity. Home ownership – for instance – is likely to pay off in the equity built versus the interest paid. The catch is that if you ever need access to cash, your home, for instance, is considered illiquid. It will take time to get the cash out and it is an unknown how much there will be when you do sell it.

The benefits of ownership and equity built are the benefits here.

This example shows how having money in the bank vs. owning property or a business can have different risk/return characteristics. When looking at the investment market, where you hear ‘bond’ simply think ‘debt’ and where you hear ‘stocks’ simply think ‘ownership.’ Depending on when you need cash – we call this time horizon – one investment will make more sense compared to another.