There’s No Such Thing As A Safe Investment
One question I often hear is, “What is the safest way for me to invest my money?” I hate to burst your bubble, but there is no such thing as a “safe” investment. Even putting your money in an FDIC-insured “guaranteed safe” savings account is risky. Wait, what? Isn’t a savings account the least-risky place for your money? Not necessarily. Let’s define what I mean by risk.
There are three kinds of risk to which investments are subjected: market risk, inflation risk and emotional risk. Every investment, including investing in a house, an education or a stock, is subject to at least one kind of risk. Market risk is the one that gets the most attention because it’s what you suffer from when the stock market plunges and your 401k balance is cut in half. But if you only invest to protect yourself from market risk but sticking with bonds or CDs, you’ll suffer from one of the others.
Inflation risk is slower and less obvious. You’re not going to see a news report on how you lost 2 percent of your savings due to inflation in one day. Instead, inflation risk eats away at your purchasing power over time. For example, if you bought a new car today, it would cost you about $26,000. If the next forty years of inflation reflect the previous forty, the same car will cost you $145,000 in 2053 [Source: Worth It… Not Worth It? by Jack Otter].
It feels safer to keep your hard-earned savings in cash or CDs because you won’t ever see it dissolve in a flash crash of the market, but what you’re really doing is just trading your market risk for inflation risk.
Emotional risk is actually the biggest risk for all investors. Waiting to buy until you see that the market is doing ok has you buying high; selling when the world seems to be going to hell in a hand basket is selling low. Surely you’ve heard the adage, “Buy low, sell high.” Emotional risk is what causes most people to do the opposite.
The next time you quaff about investing in the stock market because you don’t think you can stomach the risk, remember that it’s just market risk that you’re acknowledging. Avoiding it guarantees you inflation and emotional risk. To mitigate, you need to invest in a diversified mix of stocks, bonds and cash. The exact allocation to each class will depend on several other factors and is a topic for a future column.
To account for emotional risk, you should set your account to automatically rebalance at least annually, if not quarterly. Most 401k plans and online investment accounts allow you to do this, which keeps you from letting your emotions get in the way of smart investing.
We’ve answered the question of why you should invest, but keep in mind that you shouldn’t invest any money that you know you will need within the next 5-7 years. What other questions do you have about investing? Please let me know in the comments.