I’m sure there are many out there who are saying the answer to the questions is obviously cash. Stocks go up and down in value, and you could lose all of your money if you are in individual stocks. Cash just sits there and waits for you to spend it. As long as you are safe from robbery, if you have physical cash, or fraud or a bank run, if the cash is sitting in the bank, then obviously cash is safer than stocks, right? Not exactly.
Put a dollar ten-dollar bill on the table in front of you and stare at it. Not doing anything, is it? Believe it or not, that ten dollars is being stolen right before your eyes. Don’t believe it? Put the ten-dollar bill away and put a one-dollar bill in its place. If you kept that ten-dollar bill in your mattress from the time you started working until retirement, the one-dollar bill would be what you would be pulling out when you retired. It would still look like the ten-dollar bill, but it would buy a soda in some vending machines or maybe a half-gallon of gasoline. Because of inflation, the value of cash money is being stolen all of the time, even if the bills are physically safe.
And this leads us into the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life. (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the sidebar.) Today we cover the fifth rule:
5. If you need it in five years or less, save in cash. If it is ten years or more, invest. If you’re in between, invest but only if you have a back-up plan.
The returns of stocks over one, two, or three years are unpredictable. You could end up with more money or less. If you invest in a diversified basket of stocks (for example, you invest in a three different index funds that cover different segments of the market), over most five-year periods, you’ll end up with more (maybe a lot more, maybe just a little more). Over ten-year periods you’re almost assured of ending up with more and earning a return of maybe 8-20% annualized per year. Over a fifteen year period of time, things start to settle in and you can almost count on an annualized return of 12-15%. For periods longer than that, your return will remain in the 12-15% range.
Note you can use the rule of 72 to estimate how much your portfolio will be worth in periods of time more than 10 years. Simply divide 72 by the annualized return and that will tell you how long it will take for your portfolio value to double. For example, if you earn 12% annualized, your portfolio will double about every 6 years. This means in 12 years your portfolio will be about four times what you started with ($10,000 will be $40,000). In 18 years, you’ll have eight times as much ($10,000 will be $80,000).
If you have money that you absolutely need in a few years, investing in stocks would be very risky unless you have a lot more money than you need. For example, if you are planning to go to college in two years and need $20,000 for the first year, you would not want to have the money invested if you only had $25,000 saved. You could just as easily have $15,000 in two years as you could have $30,000. If you kept the money in cash, your money might only buy what $24,000 bought two years before – meaning college costs may have gone from $20,000 to $21,000 or $22,000, say – but at least you would be assured of at least having that much spending power.
For money not needed for ten or more years, you really need to invest because otherwise not only will you miss out on a much better return on your money than you’ll find in savings accounts or even bank CDs, but you will also see the spending power of your money decline if you don’t. This decline will probably be fairly gradual, maybe 1-4% per year, but it could be very rapid should we see hyperinflation again as was seen in the 1970’s.
For periods of five to ten years, it really is a crap shoot, although the odds are somewhat in your favor if you invest. If I really needed $20,000 in seven years and I had $25,000 saved, I might choose to keep it in a five-year bank CD and just work and save more to fight inflation. If I had $40,000, I would probably invest it, figuring that even if I saw a loss of 50% I would still have the money I needed. I would invest in mutual funds instead of individual stocks in this case since I could well see a 100% loss in an individual stocks, while even a 50% loss in mutual funds would be unlikely. I could also put $20,000 away in a bank CD and invest the other $20,000. That would be the best option because then I’d be assured of having at least $18,000 after inflation, and I’d probably more than the $20,000 I initially invested in the investment account.
So for money that you won’t need for a long time, like children’s college funds when they’re infants or retirement funds when you’re younger than fifty, invest the money. For money you absolutely need in a few years, put it in a bank and get the best return you can while still staying in safe bank products with assured returns. For things in between, invest if you have more than enough, and save if you have just enough.
Got an investing question? Write to me at VTSIoriginal@yahoo.com or leave a comment.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.