Liquidity, Safety and Rate of Return: 3 Essential Elements of Investing

Suppose someone were to approach you with an investment opportunity for your consideration. There are 3 key questions you’d want answered before committing your money. If you don’t understand these questions you may have a Missed Fortune.

1. Can I get my money back when I want it back? 
2. Is it guaranteed or insured? 
3. What rate of return can I expect?

Now let’s look at a couple of hypothetical investment opportunities.

In our first example, you get to determine the amount of your monthly contributions and the length of time you wish for them to continue. You can pay more than the monthly contribution, but not less.

If you attempt to pay less, the financial institution keeps all of your previous contributions. The money deposited in the account is not safe from loss of principal. In fact, each contribution you make to this account results in less safety.

The money in the account is not liquid should you need to get to it. The money in this account earns a 0% rate of return. Your income tax liability increases with each contribution you make. Finally, when the plan is fully funded, there is no income paid out.

Few people would argue that this is a prudent investment. Yet this is a textbook description of a house with a traditional amortized mortgage.

Our second investment opportunity involves burying a $100 bill in a tin can in your backyard. It’s liquid in the sense that you can access it. It’s safe so long as your dog doesn’t dig it up before you do. But it’s not earning a rate of return.

These two examples illustrate why a solid investment opportunity must include the 3 key elements of liquidity, safety and rate of return.

Liquidity is your number one priority. This means that, where your home is concerned, your equity must be moved to a position of liquidity where you can still access it even if your home were to be destroyed in a disaster. It also rings true if your money is in the stock market. What if you were to lose your job and need to make your mortgage payment for the next four months while you find work? With liquidity you can weather the financial storms of life.

Safety of principal can best be illustrated by what happened in Houston, Texas in 1980 when oil prices dropped drastically. More than 16,000 homes were foreclosed on at that time when people could no longer make their mortgage payments.

It didn’t matter if those folks had been paying an extra $100 a month toward their principal; the banks foreclosed when the mortgage payments stopped.

It seems counterintuitive but in a soft real estate market, those with the greatest amount of equity are at the greatest disadvantage. Given the choice between foreclosing on delinquent mortgage-holders with a high mortgage balance or a low balance, mortgage companies will nearly always go after those who have more equity.

The reason is obvious: it’s easier for them to sell the property and make back their money when there is high equity. In fact, the bank is often far more willing to work with those who owe more. Safety of principal is found in separating that equity from the property.

Which brings us to our final element.

The rate of return on home equity is always 0%. Always.

When you buy a house or refinance, you will always incur opportunity costs when you leave your equity in the property. This means that by keeping your money tied up in your property, you are giving up the opportunity to earn any rate of return.

On the other hand, if you separate that equity from the property, you can put that money to work earning a rate of return. Any good employee returns more in value than he or she costs her employer. Putting your money to work is no different.

Employment costs will always trump opportunity costs when it comes to earning a rate of return. This is especially true when the miracle of compounding comes into play.

These three key elements of liquidity, safety and rate of return are at the heart of the Missed Fortune strategies that help people build real wealth.

Leave a Reply

Your email address will not be published.