Any investment decision will be influenced by three objectives – security, liquidity and yield. A best investment decision will be one, which has the best possible compromise between these three objectives
Individually these objectives are very powerful in influencing the investors. Collectively they work against each other forcefully, as can be seen below. Hence the acclaim – A best investment decision will be one, which has the best possible compromise between these three objectives
When selecting where to invest our funds we have to analyse and manage these three objectives
Security: Central to any investment objective, we have to basically ensure the safety of the principal. One can afford to lose the returns at any given point of time but s/he can ill afford to lose the very principal itself. By identifying the importance of security, we will be able to identify and select the instrument that meets this criterion. For example, when compared with corporate bonds, we can vouch safe the safety of return of investment in treasury bonds as we have more faith in governments than in corporations. Hence, treasury bonds are highly secured instruments
Liquidity: Because we may have to convert our investment back to cash or funds to meet our unexpected demands and needs, our investment should be highly liquid. They should be en cashable at short notice, without loss and without any difficulty. If they cannot come to our rescue, we may have to borrow or raise funds externally at high cost and at unfavorable terms and conditions. Such liquidity can be possible only in the case of investment, which has always-ready market and willing buyers and sellers. Such instruments of investment are called highly liquid investment
Yield: Yield is best described as the net return out of any investment. Hence given the level or kind of security and liquidity of the investment, the appropriate yield should encourage the investor to go for the investment. If the yield is low compared to the expectation of the investor, s/he may prefer to avoid such investment and keep the funds in the bank account or in worst case, in cash form in lockers. Hence yield is the attraction for any investment and normally deciding the right yield is the key to any investment
Relationship: There is a trade off between risk (security) and return (yield) on the one hand and liquidity and return (yield) on the other
Normally, higher the risk any investment carries, the greater will be the yield, to compensate the possible loss. That is why, ‘fly by night’ operators, offer sky high returns to their investors and naturally our gullible investors get carried away by such returns and ultimately lose their investment. Highly secured investment does not carry high coupon, as it is safe and secured
When the investment is illiquid, (i.e. one cannot get out of such investment at will and without any loss) the returns will be higher, as no normal investor would prefer such investment.
These three points – security, liquidity and yield in any investment – make an excellent triangle in our investment decision-making. Ideally, with given three points of any triangle, one can say the center of the triangle is fixed. In our investment decision too, this center – the best meeting point for S, L and Y – is important for our consideration.
However, if any one or two of these three points are disturbed – security, liquidity and yield in any investment – the center of the triangle would be disturbed and one may have to revisit the investment decision – either to continue the investment or exit the investment.
All these points – security, liquidity and yield – are highly dynamic in any market and they are always subject to change and hence our investor has to periodically watch his/her investment and make appropriate decisions at the right time
If our investor fails to monitor her / his investment, in the worst circumstances, s/he may lose the very investment
Thus, we will return to our original statement – A best investment decision will be one, which has the best possible compromise between these three objectives – security, liquidity and yield.