When you’re saving for the future, how should you invest the money? There’s a wide range of possibilities, from safe-and-steady bank certificates of deposit (CDs) to risky-but-fast-growing stocks. Each type of investment serves a purpose. Choosing the right mix isn’t hard, once you understand the rules.
First, two big questions to think about. How you answer will suggest the most appropriate types of investments for you today.
#1: When will you need to spend the money that you’re currently putting away?
Savings needed in four years or less should be put in an absolutely safe place: money-market mutual funds, bank CDs, Treasury bills, or Series EE savings bonds. Although these investments earn low returns (at this writing, about 5 percent), your money will be there whenever you want it. In this category, I’d put emergency savings, money for a down payment on a house, and any college tuition payable within four years. This is your “cash portfolio.” Savings you won’t touch for four years or more should be invested in stocks and bonds. Big-company stocks have returned an average of 12.6 percent annually since 1950, assuming all dividends are reinvested; five-year government bonds earned 6.2 percent. This is the kind of growth you need for a young child’s college fund or for your own retirement nest egg. (By stocks, I mean well-diversified stock-owning mutual funds. Individual stocks are a much higher risk.)
Why the four-year rule? I asked Ibbotson Associates, a Chicago investment-consulting firm, to tell me how long it has taken, in the past, for the stock market to recover after a drop in price. (By recover I mean rising back to its value prior to the decline, assuming that dividends were reinvested.) Since World War II, the market has come back in about two years on average. The longest recovery period was three and a half years, following the downturn that started in 1972.
If you’ll need your money in fewer than four years and invest it in stocks, there’s a risk that the market will fall and not recover in time. But if you can leave your money untouched for a longer period–and ride out a decline–you should wind up ahead.
#2: How comfortable are you with stock-market risk?
Stock prices usually go up. They’ve risen in 35 of the years since 1950 and fallen in only ten. In those ten years, the average loss came to 9.6 percent. In one painful year (1974), the market dropped 26.5 percent. A confident investor, however, ignores such drops. Eventually stock prices recover and rise to new heights. Since 1974, the average price of America’s leading companies has risen about 950 percent.
But some people can’t stand the stress of watching their investments shrink dramatically, even though they know it’s only a temporary, loss. That’s where bonds or bond mutual funds come in. Bonds rise and fall in value, just like stocks, but their ups and downs aren’t as violent. If you invest in stocks and bonds, your total portfolio (meaning all of your investments) won’t rise as much as an all-stock portfolio. But neither will it fall as much when the stock market drops. In other words, adding bonds reduces risk. (To appreciate this, remember not to look at stock performance alone. Always average it with the performance of your bonds.)
It’s usually said that, at age 30, you should own more stocks than at 50, because young people can afford more risk. But that depends on who you are. As long as you’re investing for the long-term-more than four years–you can buy as many stocks as you’re comfortable with, at any age.
Now that you’ve established what you need and what you’re comfortable with, how do you decide how much money to put into each broad type of investment? Some simple rules:
1. YOUR CASH PORTFOLIO: There’s no ideal percentage to keep in cash (cash includes short-term CDs, Series EE savings bonds, and money-market funds). It all depends on your need for ready money in the next four years. But segregate only the money that you know you’ll need for a specific purpose. Money you may not need should be invested for a longer term.
2. YOUR TAX-DEFERRED RETIREMENT PORTFOLIO: Contribute the maximum allowed to an employer plan or a plan for the self-employed. Don’t say, “I can’t afford to save,” until you’ve tried it. Most people succeed, as long as the money is automatically deducted from paychecks. Split your retirement money between stocks and bonds, in line with the risk you’re willing to take. (See table at left.)
3. INVESTMENTS OUTSIDE YOUR RETIREMENT PORTFOLIO: Most commonly, this would include any money you’re saving for your children’s education–also split between stocks and bonds. In order of priority, maximize your retirement savings, then start an education fund. Few parents save the total cost of a college education. They cover tuition with a combination of savings, current earnings, and student and parent loans.