The Magic Triangle of Investing Your Money
Understand investing & the most important factors
No matter if you invest in stocks, loans, raw materials, fonds, real estate, art, or anything else — the principle of the magic triangle, what I present to you, can be applied to all kinds of investments — and you should.
Why should you understand this principle? Because it gives you a basic understanding of the world of investment.
It will also allow you to evaluate investments and their pros and cons better, and to become skeptical if someone presents you with an investment that does very well in all three or even just two of the corners.
Here are the basics:
- Return: How much profit can be made with an investment.
- Risk: How safe this profit is and how safely the profit can be planned. (In the long run, shares offer almost only the chance of profit, but there is no certainty that the profit can be realized at any time, due to potentials dips in the course.)
- Liquidity: How easily and appropriately, the investment can be converted back into money.
And believe me, this triangle is irrefutable because the relationships within it are rational.
One relationship you can read from the triangle is that return comes only from risk.
If you want to lend $100 to someone who is extremely low on cash, it is a high-risk investment. Assuming that the loan is official and that it will be seized in case of insolvency until you get your money back, the risk is that you won’t get your money back in time.
And that has to be compensated with something. You wouldn’t just give away $100, so you expect interest. And the higher the risk is, the more interest you would take to make you pay for the risk you took.
The market functions would also agree with this:
If two different people, both asking for a $100 loan from you and both are offering 5% interest, you will take the one that provides higher security.
The one that is more likely to run into payment difficulties and therefore represents a higher investment risk would have to follow suit and offer you more interest so that he can get the loan from you.
Why Is It Called Magic?
Because no investment, in reality, covers all three goals represented by the corners.
The goals are, of course, also more of a spectrum. There is not one investment that can be considered secure or liquid, and it is generally difficult to quantify and compare these characteristics. Most of the time, this can only be done roughly.
Investments, therefore, cover a maximum of two of these objectives. Some even include only one, but the remaining goal is correspondingly intense.
The best way to imagine the functionality is to imagine 100 points.
These points indicate which priority you have for a goal. So you can then distribute the ends to the targets.
For example, you could give 30/20/50 points or even 5/5/90.
But the points are always limited to 100.
As I said before, this triangle can also help you to see through offers that sound too beautiful. No investor in the world can resist the economic nature of this triangle and its relationships.
In reality, there are funds in which you can invest, which offer a profit guarantee.
What, of course, sounds very attractive for investors is to be placed in the magic triangle in the direction of security. But logically, this additional security must be compensated for by something — after all, no one in the world can make a 100% secure investment.
And the compensation is real: Most of the time, such funds can only guarantee profits by having reserves at the expense of returns, or by having a large proportion of defensive investments that generate small but positive returns every year.
In the case of such a profit guarantee for every year, the security increases, but the return is reduced.
Why Is It Called Magic?
It is essential to understand that an asset class such as stocks, for example, do not all have the same valuation in the magic triangle. Of course, there are differences in each share or index. This also applies to the different commodities and types of real estate, by location, size, and so on.
An investment in the MSCI World
The MSCI World comprises more than 1600 stocks from industrialized nations around the world. This means that it contains the shares of huge and established companies such as Apple, Nestlé, Procter & Gamble & ExxonMobile.
In most cases, such shares are characterized by lower volatility, i.e., the stocks tend to fluctuate less in price. On the other hand, their returns are, on average, not as strong as those of small-cap companies. (In principle, smaller companies usually achieve higher returns, as the risk of the investment is greater)
Why did I just talk about volatility? Because with stocks, a decisive factor is a time at which you want to sell. So, depending on the share or index, you can, of course, trade in a slump and only reap losses. The MSCI World is, of course, not entirely stable either, and like the entire global stock market, it collapses during crises such as the financial crisis or the corona crisis.
But the certainty that one has made a positive investment at least in several years, perhaps even decades, is almost 99%. As is well known, the global equity market returns only positively nearly every year, except for the crises, which only hurt the growth in the short term.
In terms of liquidity, we now have to consider safety. Of course, it is possible to sell your entire portfolio in a matter of seconds this day. Still, at many times you would instead not do that — in a crisis, for example, or otherwise, when there are slumps that can never be ruled out due to the volatility of shares.
So, to sum up:
- Return: Good. At least in the long term, approx. 6% annually on average.
- Security: Due to short-term fluctuations rather mediocre.
- Liquidity: Also, rather mediocre due to the fluctuations mentioned.
A 100% debt-financed apartment
We buy a 60sqm apartment for 200.000$ entirely financed by debt, with the credit we got from a bank.
The flat is rented warm with 1300$ per month; since it is located in a big city like Paris, London or New York.
The loan that we have taken out naturally has a long term and the money that remains in the rent after house money we use to repay the loan.
Thus, one pays off the apartment over several years, but of course one can also take a small passive income from the rent, but then has to repay the loan for a longer time. (I do not carry out an exact calculation because I only have a moderate knowledge of real estate)
A further prospect of return is the fact that, depending on the location, real estate continues to increase in value over the long term. After all, apartments are always needed, and cities, in particular, are growing.
So we have a long-term investment, which we could even multiply because we have not yet used our own money.
Many people would not be able to sleep well with a loan of $200,000, but de facto the investment is always matched by the property that we can call our own. Moreover, real estate does not fluctuate in value as much as shares, and the valuation of a property is also much more difficult.
And this is the big problem with real estate: Liquidity is inferior.
Making the property cash again involves an extreme amount of effort, perhaps even a loss, if the valuation is to our disadvantage, and we have not yet paid off the loan by far.
So, to sum up:
- Return: Average to good. Finally, we have to use it to pay off the loan.
- Risk: Very low. At any given time, our debts are matched by a similar value of the property, we have the right to the property, and the market tends to be stable.
- Liquidity: Very bad. It costs a lot of effort to sell the property again and may take longer. There is no guarantee that we will get back exactly the purchase price or more.
An extreme example: money in a bank account
Instead of investing our money in the property, we prefer to invest it in our call money account.
- Return: Very bad, if not negative, since inflation is devaluing our money more and more.
- Risk: Extremely low. Above all, thanks to the deposit insurance, which guarantees that we will get our money back even if the bank becomes insolvent.
- Liquidity: Extremely good. Our money is always available; we can even pay online with it.
So as you can see, money in the account is an extreme case that even cuts into two corners of the triangle. In return, it compensates for this with the extremely poor, if not negative, return.
20 year old writer from Germany - Tech, Finance, Philosophy & Psychology