Stock market-sensitive investments, including mutual funds that own stocks, can realize an attractive return when considered over long periods of time. By “long” I really mean 20-year time periods or greater. If you’re one of my college students, or former students with a 30- or 40-year timeframe to be invested, you have a wonderful opportunity to accumulate wealth through consistent savings and investing for growth.
Many novice investors (and some professionals more interested in sales than good advice) might say that “long term” is three, five, or even 10 years. A review of the evidence concerning past results will reveal that the level of historical predictability for these time horizons is questionable. There’s a large and easily accessible body of academic work on this topic, so I won’t get into the details of substantiating my claim in this short post.
For your short-term need for capital, i.e., money you can use to meet daily needs or payments due, there is nothing better than cash accounts. The money is available immediately and with no risk of changes in value due to market fluctuation when invested in an insured bank account or with a reputable investment fund. The problem is that cash and cash-equivalent investments like Treasury bills and short CDs earn very low returns—in today’s world, at or under 1 percent. Clearly not the place for money needed in the distant future.
Bonds and other fixed-income investments issued by the US government, corporations, or municipalities are securities with maturities (the date when your principal is paid back) that can range from a few months out to 30 years or longer. Normally (but not always), longer-term bonds pay higher rates of interest because the money is committed for a longer period of time and the higher return offsets some of the uncertainties (such as inflation) of the longer investments. These fixed-income investments can usually be sold but will change in price based on the prevailing interest rates and any changes in credit quality.
So, how do you choose how much of your savings to invest in stocks, bonds, and cash? A primary consideration is the time horizon of the investment, as well as your ability, need, and willingness to accept risks and uncertainty.
If you are a 20-something just out of college and saving money for a retirement in the distant future, you should be sure you understand the higher potential return of stock investments, while also considering the unpredictability of results in the short run—anything under 20 years, really.
But let’s say you are mid-career and building wealth in your retirement accounts, yet you have some cash left in your checking account to invest. You have children headed to college, and you want to help them along the way to a solid education. The money used for tuition payments should be readily available in a cash or very short-term cash-equivalent investment. Investing this money in stocks converts a long-term investment into a short-term speculation and is not recommended.
The purpose of bond investments is for the stability of principal in the portfolio and for very modest income, somewhat greater than cash but not nearly has high as the forward-looking return expectations associated with stocks and other equity holdings over long periods.
The bottom line is illustrated by this chart:
(less than 1 year)
(1 year to 10 years)
Based on your time horizon, there is some mix of stocks, bonds, and cash—your “asset allocation”—that is right for you given your individual goals. Your willingness, need, and ability to accept risk and uncertainty must also be carefully considered. Your wealth adviser is the professional that can help you with this decision.
If you need assistance finding the right financial professional to serve you, get a copy of my book The Eight Points of Financial Confidence for a step-by-step guide to identifying and hiring the right wealth adviser.