Investing is putting your money to work so it can multiply—which sounds great on the surface. But I’m not the first to tell you that the problem with investing is that it is risky. You could lose everything.
Solomon, the wisest man who ever lived, said, “There is another serious problem I have seen under the sun. Hoarding riches harms the saver. Money is put into risky investments that turn sour, and everything is lost. In the end, there is nothing left to pass on to one’s children” (Ecc. 5.13-14, NLT). Solomon knew that if you just save, your money isn’t really multiplying, but he also knew the reality that you have to risk in order to profit.
All investments have pros and cons. How do you evaluate an investment to minimize risk? I have a litmus test when investing. I call it the SLR recipe—for Safety, Liquidity, and Return.
First, S is for safety. How protected is my money from loss? Can I lose my money? Is there any way that I can lose my principal?
Many of my clients have noticed that I’m not as worried about the return on their money as I am in the return of their principal. Investors who prioritize safety understand the value of a dollar.
Analyzing the riskiness of the investment is a crucial factor to consider when investing. It takes a lot of effort to dig yourself into a hole, but it can take even more work get yourself back where you started. The last thing you want to do is feel like you’re going backwards.
On the flip side, safety will cost you if you play it too safe. You take certain risks by being too conservative. In the financial world, this is called “purchasing power risk,” which is where things become more expensive over time, so if your investments don’t keep up, you will lose ground. Historically, inflation has averaged 3 to 4% per year, so be cautious that your fear of risk may cause your savings to depreciate in the long run.
Next, L is for Liquidity. How accessible is my money? Can I get it out quickly if I need to? If I need to convert my investment to cash in a hurry, how difficult is that? What is the time commitment on my investment? Liquidity either makes you money or loses your money.
Liquidity is essential because you need to have access to your funds. Maybe you’re waiting for your dream home to come on the market, or you want to take that long-awaited cruise you’ve been planning for years. Liquidity is an important factor because when your money is liquid, you can enjoy it and also quickly move to take advantage of opportunities others cannot.
On the other hand, liquidity can cost you a better return if you have too much of it. Having too much money on hand can lead to depreciation which can cause you to lose money in the long run. Numerous families have more than enough for their immediate needs and their rainy-day fund, but then they have extra in a CD or Money Market in the bank. Instead of letting it sit there with a 1 to 2% return that won’t keep up with inflation, they would do well to invest that extra so it can grow.
3. Rate of Return
This pillar is by far everyone’s favorite: rate of return. What kind of profit can I easily expect? Rate of return is the percentage of appreciation or income on a yearly basis that you can expect from the exchange of your money for the investment.
The rate of return is synonymous with investing because of the power of compound interest, which is the only way to coast up hill. Once the magic of compounding is really working, your money will eventually be earning more while you sleep than when you are awake.
At first glance, it’s enticing to want a great rate of return. We all dream of making it big with a certain stock or a lucrative real estate investment. It’s widely accepted that the stock market and real estate markets have outperformed inflation and other asset classes over the long term.
On the other hand, countless investors have been lured by this singing siren of greed. Retirees have made the mistake of taking on more risk to try and “catch up,” but then they take three steps back when the market corrects. Find a financial advisor who refuses to sugarcoat historical returns and will show you how their portfolios performed during 2001 and 2008.
When deciding on an investment, don’t fool yourself, and don’t let anyone fool you. Never sugarcoat the forecast of an investment, and don’t assume you will make the same forecast.
Always keep safety, liquidity, and return in mind before making an investment. When you’re putting your money to work so it can multiply, these can help you minimize risk and get the best return.
There is a caveat to the three factors: No investment has all three. At best, you will have two of the three. There is no such thing as a perfect investment. The key to investing is to make sure that you diversify so that you benefit from safety, liquidity, and return. Check out our blog covering the four different types of investments from this lens.
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