Let’s move into a new topic we haven’t explored in detail before – investing. This will help with our two New Year’s resolutions dealing with saving for goals and make investing easy. Your different savings goals need different investments. Your short-term savings like emergency fund and home down payment should be in safer investments such as a savings account, certificates of deposit, or money management fund; while your long-term investments like retirement and college savings should be in higher paying investments like stocks, mutual funds, and ETFs. Why? Because of the trade-off between investment risks and rewards. So before we get to the fun stuff of how to pick investments, let’s explore the fundamentals that should guide our investing.
Risk versus Reward
All investing is a trade-off between risks that you will lose money versus how much reward will you get for your investment. The higher the risk of losing your money, the higher the reward to entice you to invest. The less risk of losing your money, the less someone is going to pay you to invest. This is why savings accounts and treasury bonds are super safe, but pay little, while stocks can lose huge amounts of money, but can earn very nice amounts, too. Even investments in stocks can be diversified into safer and speculative.
It is important to know that investments may have several kinds of risk:
Losses – We all know that we can lose some or all of our money in certain investments like stocks because the value goes both up and down, whereas the money in savings accounts will not decrease.
Inflation – Another risk is that inflation will grow faster than our savings and therefore the buying power of our savings will decrease, meaning our future savings will buy less than today. If your savings do not grow faster than the rate of inflation, then your savings will lose value or buying power as time goes on.
Liquidity – There is also the “liquidity” risk; how easily can you turn your investment back into cash when you need it without losing money. For example, it is easier to convert a savings account into cash than real estate. Stocks can be sold for cash, but will the price be lower or higher at the time you need your cash?
All investments have some risk whether from losses, inflation, or liquidity, but different types of investments have different types and degrees of risk. Stocks have greater risk of losing value in the short term, but the least risk of not beating inflation over the long term. Different types of bonds are better at preserving your capital, but falling behind inflation. Savings accounts, certificates of deposit, and money market accounts are very “liquid” when you need your money and safeguard savings well, but your money will be eroded by inflation. Even doing nothing with your savings or putting your money under the mattress risks being eroded by inflation (not to mention someone throwing away or stealing your mattress).
Your incentive or reward for taking on this risk by investing your savings is the expectation of getting a “return” on your money. You give your savings to someone to use (person, bank, business, or government) and hope they will return your money plus more. The greater your risk and the longer your investment’s future uncertainty, the more you want to be rewarded for investing and risking your savings. Conversely, the lower the risk, the less someone is willing to entice you with compensation so the less your return will be. This is why savings accounts pay so little interest; because there is little uncertainty and risk of loss or liquidity (but you will still lose money from inflation). Over an extended period of time stocks have historically provided the greatest total return (dividends plus growth). Their historical return of 7-10% usually beats inflation handily, but this is for the average stock over an extended time period. In the short term, a particular stock has much more uncertainty and, consequently, the greatest risk of loss and liquidity which should yield a greater potential return. Now it should be clear that you should be very skeptical of any promise of high returns with little risk.
Balancing risks and returns
When you develop your investing goals, you will want to balance liquidity (how easily you can get your money back), safety (preserving money from losses and inflation), and total return (how much are you rewarded for what degree of risk). Later, we will add other investing factors such as tax-efficiency and fees, but for now let’s finish risk versus reward. It’s common advice that each person must decide for them self how comfortable they are with risk and uncertainty; are they going to stay awake at night worrying or panic at the next down market? However, this advice leads too often to too many people being risk-averse at the wrong times and settling for tiny returns needlessly that don’t even match inflation. For example, many people who experience a deep bear (down) market develop a deep aversion to risk and are reluctant to invest in stocks. But this is precisely the best time to be buying stocks – when they are cheap and before you miss most of the inevitable rebound. Talk of avoiding risk also usually means avoiding potential loses, but forgets about the certain risk of inflation.
A better guideline is to concentrate on liquidity – when will you need to convert your savings investment back to cash. Stock prices will go both down and up and might take several years to recover from a deep hole. So don’t invest any money in risky stocks that you will need within the next few years – invest that money in safer investments, for example when you are within a few years form paying for the student’s college or your retirement. Conversely, don’t save your college or retirement money in safe, but low yielding money market funds when college or retirement are many years away; you will likely be missing out on many years of fat returns and your savings will even lose buying power from the erosion of inflation. Once again, let me be explicit about this common mistake that too many young savers make – when you are in your twenties, thirties, and forties, MOST of your retirement savings should be in stocks as the main investment that historically has grown fast enough to get you to the retirement savings goals you need.
In future posts, we will explore things investors can do to reduce risk and increase rewards.