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Authored by Lance Roberts via realinvestmentadvice.com,

When it comes to the financial markets, investors have a litany of investment vehicles to choose from. The choices are nearly unlimited, from brokered certificates of deposit to complex derivative instruments. Of course, investment vehicles’ proliferation comes from investors’ demand for everything from excess benchmark returns to income generation to downside protection.

Of course, every investor wants “all the upside, with none of the downside.” While there are vehicles, like indexed annuities, that can provide no downside risk, they cap the upside return. If you buy an index fund, you can get “all the upside” and “all the risk.”

However, an email from a reader last week got me thinking about the perfect “investment vehicle” and the search for the “holy grail” of investing.

• Guarantee at least a 4% rate of return.
• Allow me to withdraw cash without penalty when needed.
• Reinvest all income
• If bond yields decline as expected, the value of the investment increases.

At this point, I was confident in just suggesting purchasing a 10-year Treasury bond. At current rates, the investment would yield greater than 4% and guarantee the principal. If yields decline, the bond rises in price, reinvestment of income is an option, and the investment is highly liquid.

Theoretically, this would be the “perfect investment” vehicle for their needs. I said “theoretically” because they added one more requirement just as I was about to spout off my terrific idea.

And that, as they say, quickly ended the “perfect investment” vehicle for their needs.

Why did the addition of “price stability” make their request impossible?

The 3-Components Of All Investments

In portfolio management, you can ONLY have two of three components of any investment or asset class:

• Safety – The return of principal without loss due to price change or fees
• Liquidity – Immediately accessible without penalties or fees
• Return – Appreciation in the price of the investment

The table below is the matrix of your options.

The takeaway is that cash is the only asset class that provides safety and liquidity. Safety comes at the cost of return. Equities are liquid and provide returns but can suffer a significant loss of principal. Bonds can offer returns through income and safety if held to maturity. But in exchange for that safety, investors must forego liquidity.

In other words, no investment can provide all three factors simultaneously. While the table above uses only Equities, Bonds, and Cash, those three factors apply to any investment vehicle you may consider.

• Fixed Annuities (Indexed) – safety and return, no liquidity. 
• Certificates of Deposit – safety and return, no liquidity.
• ETFs – liquidity and return, no safety.
• Mutual Funds – liquidity and return, no safety.
• Real Estate – safety and return, no liquidity.
• Traded REITs – liquidity and return, no safety.
• Commodities – liquidity and return, no safety.
• Gold – liquidity and return, no safety. 

You get the idea.

Let’s revisit our email question.

While I initially focused on the cash requirements, these were also funds set aside for an “emergency.” In other words, these funds must be readily available when an unexpected event arises. Since “unexpected events” tend to happen at the worst possible time, these funds should never be put at risk. The need for “safety” and “liquidity” eliminates the third factor: Return.

No matter what investment vehicle you choose, you can only have two of the three components. Such is an essential and often overlooked consideration when determining portfolio construction and allocation. 

8-Reasons To Focus On Liquidity

Liquidity is the most essential factor in making any investment. Without liquidity, I can not invest. Therefore, liquidity should always remain a high priority when managing your portfolio.

I learned a long time ago that while a “rising tide lifts all boats,” eventually, the “tide recedes.” Over the years, I made a straightforward adjustment to my portfolio management, which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

Here are 8-reasons why you should focus on liquidity first:

Importantly, I want to stress that I am not talking about being 100% in cash.

I suggest that holding higher cash levels during periods of uncertainty provides both stability and opportunity.

With the political, fundamental, and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more critical. 

Chasing yield at any cost has typically not ended well for most.

Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.

Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube