This post was prompted by a recent exchange with some friends – and judging by articles I’ve read, it’s a pretty common situation. Many folks are simply keeping their savings as cash in their bank accounts or paying off their student loans with it. Maybe the recession made them more cautious or maybe they just never thought about investing.
I feel folks are missing out here, so here are my thoughts:
- Don’t pay off your low-interest debt early. There’s no point in paying low interest debt early, especially if you have student loans in the <3% APR range – unless you plan to keep your cash under the mattress, which leads me to my second point;
- Don’t keep your cash under the mattress. I mean it both figuratively and literally. Let your money work for you.
- Figure out the risk level you’re comfortable with. That means both the “liquidity” that you want at hand, and risk tolerance (i.e. willingness to risk losing your money). You can then devise an investment strategy to manage for those constraints. For example, if your only concern is to have at least 50% of your savings on hand in case of need – you can still put ALL your cash into a stock and be 100% certain you’ll have cash if needed.
- Figure out how active / involved you want to be. Do you want to do your own research on companies to invest in, are you going to track your investments regularly, or just want to put your money into an account, and then check up on it a year later.
- Invest. Make a strategy that fits your needs, and let your money work for you.
Now, let me explain:
The richest people in this country make $$$ by borrowing money at a lower rate, and then investing it for higher returns – keeping the difference. A lot of people (especially from certain cultures) hate the idea of debt, and like to pay-off loans just to feel better – but the reality is that if you can manage your money, and put it to a good use, debt is no different than a wrench – it’s just a tool to get the job done.
Keeping money in a no interest bank account does nothing for you – in fact it just deflates. (It does help the bank do what I mentioned above – get free money from you, and lend it to others at a premium.) Considering the returns on bonds, CDs and such, I would highly recommend investing in stocks, especially if you’re in it for the long run. Commodities and such are an option too, but I would advise against that as your first step into investing. Low load Exchange Traded Funds (ETFs) are probably your best bet, unless you have a set of companies that you really believe in or just want to hand-pick your stocks. Either way, stocks (or equity based investment funds) are a better option than bonds in the long run – over any 10-year historical period, stocks have outperformed bonds. That is, if you buy at the market high, right before a crash – you’re still ahead 10-years later.
Stocks and ETFs are very liquid, so if you need the money out, you can close out any position(s) and have the funds in your checking account within a few days. So if liquidity is your only concern, this shouldn’t stop you from investing 100% of your savings in the market. I’m not necessarily recommending that, but it’s what I’ve been doing for a few years now. Last year’s 40% gains were surely a nice reward for that view. The main question however is whether you expect a forced sale event: i.e. what if you get laid off at the same time your investments take a (temporary) dive? If you buy high and sell low, you’re not winning. In my case, I just assume that between unemployment benefits and credit cards, I’d have some slack to manage through the thick of such a double-whammy. As the Buffett said, the risks of being out of the market are higher than risks of being in it. =)
Speaking of buying high and selling low – you may hear folks say that right now is not a good time to move into the market because it’s had such a good run, and it’s due for a downward “correction”. Well, whoever can accurately predict that, will most certainly make tons of cash. For us mere mortals however, I would not worry about market timing (in fact, most commoners get it wrong). You can start moving money into stocks in tranches – for example you could invest $50,000 by buying $5,000 of stocks per week for 10 weeks. You’ll buy some high, buy some low, and hopefully get the benefits of “dollar cost averaging”. The downside of not moving in at once is that you’re further delaying your investment, and missing out on earnings.
So now, the question is where to put your money? Certain stocks have done well for me lately: AMC, BAC (Bank of America), MSFT (Microsoft), QCOM (Qualcomm), AAPL (Apple) and even F (Ford). I am happy to make my picks… and enjoy (or suffer) the resulting volatility and performance. The implied statement there is that I know how to pick stocks that will outperform the market, which may or may not be true. (And by definition, half the people are bound to get below average earnings.) So, if you think you can pick well – go for it! Maybe it’s a tech firm you think has potential, or an old stalwart that’s weathered many storms… or a smart pick from a professional newsletter. You can go for growth stocks, dividend yielding ones, etc.
You could also invest in actively managed mutual funds – betting that the fund manager can beat the market. If you read “A random walk down Wall Street”, you’d be persuaded otherwise… but there are plenty of pros making the big bucks for their clients. Again, they key is in picking which one to put your money in. This is a bit like picking stocks to invest in, but you’re likely to reduce your volatility.
The more humble approach is to get into an ETF (say like an S&P 500 one) and just ride the market. You will be making the market returns (historically ~10%), minus a small fee. Chances are you’ll do better with an ETF than with options above, especially if you don’t want to micromanage your investment. You also have a certain level of security, if history is any indicator of future performance. Let me explain that by showing the S&P 500 best and worst five years:
Five Best One Year Performances (in %)
Five Worst One Year Performances (in %)
You can see two points above: shocks up are bigger than shocks down (on a yearly basis) and it would have to be the worst year ever for you to lose 40% of your cash. I am making this second point as people are often too conservative with their investments – even if you’re retired and living off your savings, you should still have a portion of your money in stocks.
Hope this helps!