When planning your investment strategy, there are several types of assets into which you can put your money. In addition to stocks, you could choose bonds or other fixed-income investments, or you could take the guesswork out of investing and buy mutual funds or exchange-traded funds. Or you could put your money into more tangible investments, such as real estate. Finally, you could always buy gold and silver, or simply stash your money in a savings account or CD.
Source: 401kcalculator.org via flickr.
While there is no one correct formula, having too much of your money in low-risk investments can be dangerous. Doing so almost definitely puts you at a disadvantage over the long run.
Sure, stocks may go down this week, this month, or this year
However, when you invest for the long run, you don't have to really worry about what your shares are doing over short periods of time.
Stocks inherently are more volatile than many other types of investments. However, over the long term, they tend to go up more than any other investment.
This has been the case historically. Over any economic cycle, the stock market has outperformed every other major asset class, including bonds, real estate, and gold.
Bonds aren't as "low risk" as they seem
It is a common misconception that bonds don't come with much risk. After all, as long as you invest in quality bonds, you'll receive a consistent payout until the bond comes due. While this is true, the value of the bond itself, especially those with a long time until maturity, can fluctuate quite a bit.
This is especially true when interest rates are low, as they are now. All other things being equal (credit quality, maturity date, etc.), bonds tend to fluctuate in price based on the prevailing market interest rates, not the interest rate paid by the bond.
For a basic example, let's say you invest $1,000 in a 30-year Treasury bond, which pays about 3% interest as of this writing. However, if rates spike to 4%, the value of your bond would drop to where it would pay about 4% to a buyer, which in this case translates to about $750.
This isn't a precise example, since the actual market value would take into account that the bondholder would still receive $1,000 in 30 years, but it's a pretty close estimate.
You can see how this could erode the value of a bond portfolio very quickly, especially if the 30-year yield jumped to 6% or so, which isn't too uncommon on a historical basis.
Interest rates simply can't fall much more from the current level. There is much more room to the upside when it comes to interest rates, leading to substantially more downside risk to owning bonds. Keep that in mind in case you have the urge to build a "low-risk" bond portfolio.
How much are you leaving on the table by keeping your money in cash?
I'd like to make two important points. First, cash refers to not only paper money, but also savings and checking accounts, CDs, and money market accounts. Precious metals like gold and silver also fall into the "cash" category for our purposes because they can be exchanged for goods and services, and more importantly, because they don't earn returns in the "investment" sense.
Source: 401kcalculator.org via flickr
Second, it's always a good idea to have some or your savings in cash or equivalents. Not only does this provide a readily accessible emergency fund, but it also allows you to take advantage of investing opportunities as they develop. As a rule of thumb, I like to keep 5%-10% of my portfolio in cash at any given time.
Let's look at an example of two investors. Both save $5,000 per year over three decades. The first investor keeps his money in cash in CD accounts, which for simplicity's sake we'll say pay around 2% interest (a pretty generous estimate). The second investor puts his money in S&P 500 index funds, which have averaged about 9.4% total annual returns for the last two decades.
While this might not sound like a tremendous difference in the short term, over the long run the power of compound returns is tremendous. After 30 years, the "cautious" cash investor would have almost $212,000 in his account. Not too bad, right?
Well, the index fund investor would have more than $800,000. That's why it's so important to not be afraid to take on some level of risk. Imagine the difference between these two amounts of money in terms of quality of life during retirement.
You'll do better in the long run
Yes, you could lose money over any short period of time when you invest in stocks. However, stocks have an upward bias that causes them to outperform every other asset class over long periods of time.
As long as you put your money in quality companies (or funds), and hold on for the long run, you'll put yourself in the best possible position to achieve your long-term financial goals.
