It is easy to get confused when you ask the question, “Where should I put my money?” I felt overwhelmed when I began to research my first investments. Over time however, I’ve learned this doesn’t have to be complex. In fact, the best principle is to keep it simple. Always invest in things you understand and could explain to someone else. The simplest strategies are often times the most rewarding and the most calming on the investing nerves.
In this third installment of my Investing Made Easy series, I’ll tackle the “Where should I put my money” question. Before that however, I need to ask you a question. How much risk are you willing to take? The answer to that question will determine the direction your investing dollars go.
Managing Risk When Investing
It’s risk and the thought of losing money that keeps people up at night. Tossing and turning. Sweating. Eyes wide open, mind processing what might happen the next day in the market. I’ve been there as an investor and it’s no fun.
We can reduce the feelings of anxiety that come with investing by understanding, beforehand, what level of risk we are willing to take. In the investing world, this is called one’s risk tolerance. I can’t stress this point enough – you must think through your personal circumstances and mentally calculate how much risk you are willing to handle.
Generally speaking, as an investment’s level of risk goes up, so does the potential return. Conversely, as the level of risk goes down, so does the potential return. Think of it in terms of a line numbered zero to 100, with zero being low risk and 100 being high risk. All investments fall somewhere on that line and it’s up to the investor how much risk to stomach. It is very much an individual call. (There are even fun risk assessment tests to help you figure this out.)
One factor that helps us determine how much risk to take is how long it will be before the money we invest will be needed. For example, if money is going to be needed in less than a year, we definitely want to take on something very conservative. In fact, one could make an argument that a person with this time horizon should not be investing in the stock market at all but should park their money at the local bank.
If the money is going to be needed in five years, a person can afford to take on a little more risk. If the money invested won’t be needed until retirement 30 or 40 years down the road, a person can take on much greater risk for the simple reason they have time on their side to ride out the market ups and downs. A person in this situation can afford to weather a down year in the market because their time horizon is so far down the road
Another factor that helps us lower investing risk is a concept known as diversification. Simply put diversification means to spread around. It’s the old adage “don’t put all your eggs in one basket.” If we put all your eggs (money) in one basket (investment) and that basket gets toppled over, all our eggs will be scrambled. However, we could spread out our eggs into multiple baskets. This way, if one of the baskets gets toppled over, the rest of the eggs are protected. We don’t lose all our eggs because of a one-basket disaster.
Where Should I Put My Money?
Here are the most common places to invest. Consider each as you ask the “Where should I put my money” question.
1. C.D. (Certificate of Deposit). CDs are a savings instrument, usually found at your local bank, that generally offers a higher interest rate than a normal savings account. (When I say “higher”, it’s not that much higher.) They can offer this because when a CD is purchased, the individual is committing to have that money locked up for a set amount of time (3 months, 6 months, 1 year, etc). Usually the longer the time period of the CD, the higher is the interest rate.
CDs are a type of low risk investments. The return will be minimal. The money invested here is not liquid (or immediately available) because of the time commitment.
2. Single Stocks. As I mentioned in part one of this series, if I owned a business, I could let you buy into that business with some of your personal money. In essence, you are becoming an owner by purchasing a small piece of my company. Your return on your investment comes as my company increases in value and the value of each share goes up. You could also see a return on your investment if my company decided to pay a dividend (a cash payout) to the individual shareholders.
Single stocks investments have a high degree of risk. Remember, a high degree of risk means the higher potential reward. It also means as well, a higher degree of failure. When we invest in a single stock we are in essence placing our eggs in one basket. You are trusting that this company (which you really have no control over because your investment is so small compared to what the majority owners are controlling) will continue to grow and increase in value without missteps or internal malfeasance. It very well may and many have. But the list is too easy to come up with of companies who have gone by the wayside, taking investors and their money with them.
There is nothing wrong with single stock investing if you know what you are getting into and understand how to value a company and it’s potential for growth. However, I would say this is probably not the best place for the beginning investor. Use it later, once you have grown some assets, to diversify your portfolio and add some potential kick to your returns.
3. Bonds. Sometimes referred to as fixed income assets, bonds are a debt investment whereby a company, a municipality (a city) or the government agrees to owe you money. Think of it as an I.O.U. The investor lends the issuer a set amount of money and the issuer agrees to make regular interest payments on the bond over a set amount of time (1-yr., 5-yr., 10-yr., etc.). The end of that time period is known as the maturity date. When the bond reaches its maturity date, the issuer agrees to redeem the face value (the original investment amount) of the bond.
The income derived from a bond is predetermined and set for the length of the bond period, although the actual value of the bond may fluctuate, much like the price for a single stock. In this way, bonds provide the investor with a regular source of income, assuming the issuer does not default (failure to pay) on the bond.
3. Mutual Funds. In a mutual fund, investors pool their money by placing it the hands of an investment company who invests the money in a fund designed to meet certain investing objectives. The investment company hires a portfolio manager to actively manage the operations of the fund. An investor’s return comes as the value of the fund increases over time.
Some mutual funds are designed to generate income while others focus on investing in growth companies. There are index funds (like those available at Vanguard), that track the performance of a market index, like the S&P 500. Some funds invest only in international stocks while others track the performance of a particular sector of the market like energy, healthcare or technology. One can even find mutual funds that invest in commodities like oil or gold.
Mutual funds are great long-term investments that offer instant diversification for the investor. They allow an individual with small amounts of capital to allocate their investment dollars in an easier way than they would have been able to do on their own.
5. Real Estate. There are two basic types of real estate investing – investing in your own home and investing in rental properties. Despite the recent housing slump, purchasing your own home is still an excellent investment choice assuming you are financially ready. Investing in rental real estate should be done with more caution and only as an addition to a well-established portfolio. Rental properties require a great amount of cash to purchase and maintain. Therefore, it would be prudent to grow some wealth first to have the needed capital to back up such a venture.
Real estate is the least liquid investment I have mentioned. Once invested, it is very difficult to get your money back quickly because it is dependent on the house selling. This is not a place to park investing dollars that will be needed in the short term.
For the beginner, mutual funds are the best place to put your money. Next week in Part IV, I’ll talk some more about diversification, asset allocation and how to pick a good mutual fund.
Questions: What was your very first investment? Are your current investments, or the lack thereof, causing you some sleepless nights? What’s your most common answer when you ask, “Where should I put my money?”
Prior Post: The Beach vs. Pool Debate