The most common mistake among investors of all ages is not matching the right type of investment to their intended time horizon (how long until they need the money). We are frequently asked by clients where to invest short-term money. Nobody wants to put it in the bank when interest rates are below 1%. The problem is if you put it in the stock market, a year later you may have earned 47% or lost 39%. Those are the best and worst returns the stock market (S&P 500 index) has delivered in any single year since 1950. Naturally, the +47% sounds great, but investors get downright despondent when their account declines 39% in one year.
Some people associate the stock market with “gambling” because they feel that the outcome is unpredictable. The gambling analogy only holds true if your investment time horizon is too short. Therefore, short-term money (expected to be used in 1-3 years) should never be in the market. It should be in safe, liquid investments such as an online savings account or CD, despite the lousy interest rates.
Longer time horizon = more predictable returns
The longer your investment time horizon, the more predictable investment returns become. Over rolling 20-year periods since 1950, stocks averaged 11.3%, bonds 5.9%, and a balanced portfolio (half stocks/half bonds) 8.9%. Naturally, each 20-year period is not the same, but instead of a range of potential outcomes of negative 39% to positive 47% for stocks, the range is a much more predictable and agreeable +6 to +17%. (See chart below)
Just as it could be a big mistake to invest in stocks with a one-year investment time horizon, it is an equally big mistake to leave too much money in cash or low yielding investments for 10-20 years. For example; $50,000 kept in a savings account earning 2% for 20 years, may give you peace of mind, but it would only grow to $74,297. It would grow to $233,047 over the same period if it were invested in a combination of stocks and bonds that earned an average of 8% per year.
This concept of time horizon seems simple, but it’s surprising how often we see individuals who do not have enough safe, liquid money set aside for emergencies, and equally common are investors who have 3-10 times what they could reasonably need for an emergency sitting in cash. In the world of financial planning, we call this low hanging fruit. Common problem, easy solution.
P.S. In case you haven’t heard, past performance is not a guarantee of future returns.