I was recently posed this question by a workshop participant I'll call Rick:
"I have accumulated some money, and it is all in bank accounts. I feel like I should have some part of it invested in things like stocks and bonds. But how much? And how do I get started? I'm worried that stock prices seem like they're very high right now, but the interest I'm getting is very little."
Even though I've been teaching about investing for years, this question made me take a step back and think about that initial leap into investing. It was a challenging question to answer on the fly! Maybe you are also wrestling with this question. Or you're trying to evaluate the advice you're getting from a financial professional on this issue. So I decided to share this multi-pronged answer with you.
Here are some of the points I made in attempting to answer Risk's question.
The interest I'm getting is very little. Many savers are frustrated today by the extremely low interest rates paid by CDs (certificates of deposit), savings bonds, money market funds, and other types of interest-bearing vehicles. It's tempting to look around for something that pays a higher interest rate. And you might find some investments that say they will. But promises of significantly higher interest rates likely mean that those choices are much riskier than your insured bank account. Those promises could even be signs of fraud.
How do I know that? One of the basic rules of investing is that risk and return go hand in hand: To have the chance to earn higher returns, you have to take more risk. There is no free lunch.
Example: If CDs are paying 1% to 2% and most bond funds yielded less than 3% last year, how could another bond fund have paid 10% last year? There has to be more risk involved. In this case, it's because this is a "high yield" bond fund. It holds bonds from companies that may not be able to make their interest payments, or might not even be able to pay back these loans. These are sometimes called "junk bonds" in contrast with more credit-worthy companies whose bonds are considered to be "investment grade."
And if someone is guaranteeing you a 10% return in just 6 months with no risk, that reaches the level of too good to be true. I smell fraud in the air.
I'm worried that stock prices seem like they're very high right now. Yes, by most (if not all) measures that investors use, stock prices seem high right now. But the problem is, that doesn't tell us when prices will drop. Simply knowing that stock prices are historically high doesn't tell when is the right or wrong time to invest. Stocks could go higher. They could hover at the same level for a long time.
So we have to look further for guidance about whether, and when, to move money from savings to investments. And some of these factors are about us, not about the market.
What is your risk tolerance? Risk tolerance basically means, How will you react emotionally if your investment loses money? Investor.gov explains it this way:
An aggressive investor, or one with a high risk tolerance, is willing to risk losing money to get potentially better results. A conservative investor, or one with a low risk tolerance, favors investments that maintain his or her original investment.
Say you put half of your money in a mutual fund that's invested totally in stocks. But you panic and sell when your investment loses 20%. Your investment was too aggressive (risky) for your risk tolerance. By selling when it dropped, you locked in your losses and missed out on the opportunity for your investment to recover. Perhaps a better choice for you would have been to invest just a quarter of your money in that same stock mutual fund. With the remaining ¾ of your money in something more stable, like series of CDs, you might be able to handle seeing a small part of your portfolio lose money.
Risk capacity is a related but different concept. It refers to your financial wherewithal to handle losing money on an investment.
What does someone with high risk capacity look like? Here's one example. Stephanie earns a substantial salary in a stable job. She saves a big portion of her salary because she lives a modest lifestyle. She is 20 years away from retirement, so she won't be need any of the money she invests until years down the road. She has little or no debt, and she has an emergency fund equal to 6 months' of expenses. If she lost money on an investment, she could recover from that loss.
Martha's situation is quite different. She's a widow with three young children who has not worked outside the home in the past 10 years. She plans to go back to work, but she'll probably be in a low-paying job. She has a mortgage, a car payment, and credit cards on which she's carrying balances, plus little if any savings.
Even if Martha wouldn't worry if an investment lost money (meaning that she has a high risk tolerance), it would be very hard for her to recover financially from that loss. Her risk capacity is very low.
Many online questionnaires provided by retirement plans and mutual funds call themselves risk tolerance assessments, when in reality they combine questions about both risk tolerance and risk capacity. I think that's a good thing. These tools may even recommend how much of your money should be invested in stocks, bonds, and "cash" which includes savings accounts, CDs, and savings bonds. Look at those recommendations as a guideline, not something carved in stone. Try more than one questionnaire to see how much their recommendations differ. And try the one from Rutgers Extension which is a pure risk tolerance tool, developed by two personal finance professors.
Should I invest all my money at once? Let's say that Rick decided that he wants to invest $50,000 of his money in a stock mutual fund. Does he invest the whole amount at once? Or does he break it up and invest just part of it at a time, maybe $2500 a month, so that it would take nearly two years to invest the whole amount? (That's a strategy known as dollar cost averaging.) Dollar cost averaging could help protect Rick against investing the entire $50,000 at the wrong time. But it's actually more likely to hurt him. Since stock prices go up more often than they go down, investing the $50,000 all at once is likely to get him a better return. If he's just too worried about prices dropping right after he invests, dollar cost averaging can manage that risk for him, with the trade-off that he may get a lower return on his money.
Did this help? Rick's response. After I shared these thoughts with Rick and the rest of the group, I asked him whether I'd really answered the question. I wasn't sure what he'd say! I was happy (and relieved) when he said that my comments were quite helpful. Maybe they will help you with your investing decisions, too.