So after paying down your student loans, contributing at least the minimum for the company match in your 401k, stashing away money you absolutely cannot afford to lose, you find yourself with some extra money each month. You may want to take some additional risk with that cash and make it work for you.
Over the next few weeks, we will be sharing some tips to get you started in the investing world. To start, we will help you determine how risky you want your investments to be.
First, you must define your timeline. When is the earliest you will need this money? 1 year? 3-5 years? 10+ years? This is half of the equation. The bigger the risk, the bigger the potential reward (and also potential losses). The longer your time horizon, the riskier the investments you can make. Note I said can, not must. More on that soon.
Why does timeline matter? Well, since 1970, if you invested your money in the S&P 500 stock index for 1 year, there were 9 years when you would have lost money. Not only would you have lost money, but the amount lost could have been very severe (for example: -37% in ’08 or -26% in ’74). This is, of course, assuming you invest your money on January 1st of the year and is using Total Annual Returns, including dividends, to make the analysis simpler. If you used daily returns held for a calendar year, the results could be slightly different.
If you were able to hold the money there for 3 years, the number of losing occurrences since 1970 drops to 8. The severity of those losses drops as well, (-15% in ’02, -9% in ’74 are now the worst). If you were able to hold onto your investment for 5 yrs at a time? 6 occurrences with the worst loss being -2.3% in ’04. And if you had invested money in the market for 10 yrs? There are only 2 times you could have lost money (’08 at -1.38% and ’09 at -0.95%). Note, the indicated loss is calculated as if you had pulled out your investment of 1, 3, 5, or 10 years on December 31st of that year.
The examples above clearly show that a longer timeline allows for more risk and higher expected returns, but you also have to understand your risk tolerance. Even though you can afford to leave the money there for, say, 5 years, will you really do that? Can you watch the value of your money drop -55% from peak to trough (as it did from Oct ’07 to March ’09) and really not touch it? Most people do not have the stomach for it. When the pain tolerance has finally been breached, the majority ultimately pull out their money at the worst time, when they really should be investing more (or at worst holding tight) here. If you are not a professional investor, these are very hard choices (even if you are a professional investor, they are gut wrenching choices).
If you feel like you cannot determine your risk tolerance, Vanguard has a useful quiz which will help you determine how risky your investment portfolio should be. Once you have made that selection, you will be ready to start putting your money to work. In our next “Investing Basics” article, we will discuss where you should put your money to ensure you are well diversified and avoiding high management fees.