Saving and Investing: Risk Tolerance
What about risk?
All investments involve taking on risk. It's important that you go into any investment in stocks, bonds, or mutual funds with a full understanding that you could lose some or all of your money in any one investment. While over the long term the stock market has historically provided around 10 percent annual returns (closer to six or seven percent "real" returns when you subtract for the effects of inflation), according to the U.S. Securities and Exchange Commission (SEC), the long term does sometimes take a rather long, long time to play out. Those who invested all of their money in the stock market at its peak in 1929 (before the stock market crash) would have to wait over 20 years to see the stock market return to the same level. However, those that kept adding money to the market throughout that time would have done very well for themselves, as the lower cost of stocks in the 1930s made for some hefty gains for those who bought and held over the course of the following 20 years or more.
It is often said that the greater the risk, the greater the potential reward in investing. However, taking on unnecessary risk is often avoidable. Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called diversification, can be neatly summed up as, "Don't put all your eggs in one basket." Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929) by following a consistent pattern of adding new money to their investments over long periods of time.
Once you've saved money for investing, consider carefully all your options, and think about what diversification strategy makes sense for you. While the SEC cannot recommend any particular investment product, you should know that a vast array of investment products exists—including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, certificates of deposit, money market funds, and U.S. Treasury securities. Diversification can't guarantee that your investments won't suffer if the market drops, but it can improve the chances that you won't lose money, or that if you do, it won't be as much as if you weren't diversified.
What are the best saving and investing products for me?
The answer depends on when you will need the money, your goals, and if you will be able to sleep at night if you purchase a risky investment where you could lose your principal.
For instance, if you are saving for retirement and you have 35 years before you retire, you may want to consider riskier investment products, knowing that if you stick to only the savings products or to less risky investment products, your money will grow too slowly—or given inflation or taxes, you may lose the purchasing power of your money. A frequent mistake people make is putting money they will not need for a very long time in investments that pay a low amount of interest.
On the other hand, if you are saving for a short-term goal, five years or less, you don't want to choose risky investments, because when it's time to sell, you may have to take a loss. Since investments often move up and down in value rapidly, you want to make sure that you can wait and sell at the best possible time.
U.S. Securities and Exchange Commission (SEC). (n.d.). Making money grow (pp. 12–13). In Saving and investing: A roadmap to your financial security through saving and investing (SEC Pub. No. 009 [06/11]). Retrieved June 21, 2024, from https://www.sec.gov