It is important to understand your financial situation so you can pick investments that will work for you. Investments will range from Conservative to Aggressive, better understood as Safe to Risky. These ranges will differ based on the return you can expect, and the volatility involved with them. Volatility is the tendency for an asset to change value. An investment that is more volatile can increase in value fast, but can also decrease in value fast. The riskier the investment, typically the higher the volatility.
Conservative, or Safe, investments are places to put your money that have little risk of negative downside.
- Savings/Money Market Accounts
- Cash (Non invested money)
- Government Bonds/Fixed Income
Savings and Money Market accounts are accounts that are offered by most banks that let you make some money for just keeping your cash with the bank. This is considered a low risk investment because the money is insured, and banks are federally regulated so your money is protected. Many investors consider Savings Accounts and Cash to be the same since it is such low risk.
However, the downside is that the rates offered by these Savings Accounts is very low. According to Bankrate the average account interest rate is 0.07%. This means if you have $10,000 saved, after a year you will only end up with an extra $7.
To make matters worse, you are fighting against inflation. The fed typically aims to have inflation land around 2% annually (but as we can see sometimes they miss by quite a bit). This means that even though after a year you will have $10,007 from the savings account, inflation will chip away at that number and on average will be only worth 98% ($9,806.86). Even if your money isn’t in savings, you should always keep inflation in mind for all of your investments. Even with the low rates of Savings Accounts, most financial advisors still recommend that you have some money in a Savings Account set aside in case of an emergency.
Government Bonds are a little more complicated, but basically you are buying the government’s debt. You give your money to the government, in exchange for a fixed income rate that they promise you. In contrast to a Savings Account, buying bonds directly from the government means your funds will be locked up for the specified time period. For example, if you purchase a 5-year treasury bond today, you will make 3.44% annual return on your money, but you will not be able to have access to that money for that period of 5 years. This is a good option for people who want a low risk return, but do not need the money immediately. Keep in mind that some bond funds will allow you to withdraw money early.
Most of the time, the amount of your net worth that you want to be in safe investments correlates with your age. As you approach retirement, ideally you would have a large fraction of your investments be in Savings Accounts and Bonds. This is because you will be relying on the money soon and market downturns will more negatively affect you if you just have your money in growth assets.
Between Conservative and Aggressive investments, you have Moderate investments. These types of investments will offer more than Savings Accounts and Bonds, but carry some downside risk.
- Corporate Bonds
- Dividend Stocks
- Real Estate
Corporate Bonds are similar to Government Bonds, but instead of being backed by the government, they are backed by a particular company. Naturally this means that depending on which company you buy bonds from your risk will vary. For instance, if you buy from a top company that is reputable and has stable income, you are taking on less risk than buying bonds from a corporation that does not have income yet and is not well known. The current average Corporate Bond yield is 4.1%, but in the long term has averaged up to 6.5% (source).
Dividend Stocks kind of operate like Savings Accounts, except the value of the stocks you hold will also fluctuate in values (as well as the dividend yields). Take a company like Coca-Cola ($KO), which pays a yield of 2.87%. Not only do you get 2.87% of your initial investment each year, but the price of the stock may also increase. Since Coca-Cola is a reputable company which has been operating for over a century, it is considered one of the safer dividend stock investments.
Real Estate is an interesting investing vehicle as well. This is because we all need somewhere to live, so it feels strange treating your home as a potential growth asset. Of course you can invest in properties that you don’t live in, and some ETFs are available out there that track real estate prices. Historically, Real Estate prices have steadily continued to climb. People benefit because they get a place to live while their property increases in value. One day when they sell their house it may end up that the profit from the sale completely covered all the years of living there. Houses on average tend to increase up to 4% a year, but this can vary based on the neighborhood and nearby job availability.
Aside from just living in the house you purchased, you can also buy a house that you rent out. This tends to carry more risk since you have tenants now that you need to deal with. You could have tenants that break things, refuse to leave, or worse. The type of real estate investment I am considering Moderate in this post is referring to just purchasing a property and living in it.
It is important to remember even though assets like real estate are considered moderate investments, downturns are still possible. Back in 2008 house prices crashed by double digits. All investments carry risk.
Here when I talk about aggressive investments, I am referring to traditionally the most aggressive investments that average investors should be targeting. There are always more risky places to put your money (options, futures, margin trading, nano cap stocks, cryptocurrency, etc.).
- Market Indexes/ETFs
- Small/Mid/Large Cap Companies
Market Indexes/ETFs are places you can put your money that will track the stock market as a whole. One of the most popular is the S&P 500. This index tracks the top 500 United States companies by market capitalization (total value of the company). As an ease of trading, there are also various Exchange Traded Funds (ETFs) that will track this index, like $VOO as an example. Market Indexes and ETFs are still an aggressive investment, but risk is spread out between companies. Other ETFs will track the total stock market ($VTSAX), small cap companies ($VB), international funds ($VTUS), etc.
If we look at the S&P 500 index, it has an average annual return of 10.5% since its inception (note past performance is not an indication of future performance). This rate of return is significantly higher than any of the Conservative or Moderate investment options we explored. It is important to remember that this higher potential return comes with a larger risk.
If you are interested in doing some research and picking out brands you like, you can also invest in individual companies. I only recommend doing this if you are willing to put a good amount of effort into research. It is important to remember that most investors are unable to achieve higher returns long term as compared to an index like the S&P 500.
For those of you who are not dissuaded, there are many examples of individual companies that experience explosive returns. One of the largest examples is Apple ($AAPL). Over the past decade Apple shares have an average of over 43% a year, over 4 times the average of the S&P 500! The problem is that we don’t know how the next decade will go. It could get better, it could stay the same, or it could get much worse. Before picking individual stocks like Apple, make sure to do some research about the company’s fundamentals, and manage your risk (don’t put all your eggs in one basket).
Aggressive investments are more suited for investors who have a large time horizon left in their life. If you are about to retire in a year, stay away from these tempting investments. If a market downturn occurs, it may take years for assets to recover in value. This is time you do not have since you need to withdraw the money to survive. If you are young, there’s a better chance you can wait it out.
Some great news about investing is that you don’t have to just pick one option. You can create a balance between all 3. Typically you want to start almost totally Aggressive when you are young, end up Moderate when you are middle age, and have most of your assets be Conservative when you are ready to retire. Lets take a look at some sample portfolios courtesy of the investing platform Acorns (Affiliate link: Get $5 after you make your first investment!):
Conservative
This Conservative portfolio consists of only bonds. This portfolio has the least amount of risk, but also a limited upside (The Acorns conservative portfolio is still more aggressive than money in a Savings Account).
Moderately Conservative
This Moderately Conservative portfolio is beginning to add some large and medium company stocks, still with a majority of US bonds.
Moderate
The Moderate portfolio has a balance of small to large company stocks and bonds.
Moderately Aggressive
This Moderately Aggressive portfolio reduces the bond position to only 20%, the rest is in small to large company stocks and international stocks.
Aggressive
The final Acorns portfolio option is the Aggressive portfolio. This eliminates all bonds, and only contains company stocks.
The offered Acorns investment portfolios don’t utilize all the options we have explored above, but are a good benchmark for how you should be constructing your portfolio. Again, as you come closer to needing access to your funds, shift toward a more conservative portfolio. If you won’t need the money for a long time, don’t be afraid to go with an aggressive stock portfolio.