A Dangerous Distraction
Dec 23 2009
With money market funds and short-term CDs paying next to nothing, investors are anxiously looking for higher-yield investments. This is a dangerous distraction that has caused many of them to forget why they put their money in these securities in the first place: safety.
A higher rate of return is attractive but higher returns inevitably involve higher risks. So if your primary objective is safety (that is, getting a dollar back for every dollar you invest) taking on more risk, even with the promise of a higher rate of return, could be a big mistake.
Choosing between higher returns (and greater risk) or safety (and lower returns) has everything to do with your investment objective. You have to distinguish between investment capital and savings. Investment capital is money that can be set aside for the long-term while savings consists of money needed to pay near-term financial commitments and emergency funds. If you know that this money must pay for Johnny’s tuition in six months, then safety is paramount and you need to keep that money in a money fund or a six-month CD. The same holds true for an emergency fund. If you unexpectedly need to tap into your emergency fund to fix a leaky roof, you don’t want to come up short because your bond fund has dropped. This is “safe” money so you just can’t take chances with it.
On the other hand, if this is investment capital then looking for higher returns is probably the right thing to do. I define investment capital as money that you don’t expect to need for at least five years. Five years is roughly equivalent to a full market cycle so if you invest at the start of the down portion of the cycle, you want to be reasonably certain that you can stay invested and recover your losses through the up portion of the cycle. If you can’t expect to stay invested for five years then you should stay in money funds, CDs or short-term bonds.
Choosing between higher returns and safety isn’t always easy but it is helpful to remember what Will Rogers used to say on the subject: “I am more concerned about the return of my money than the return on my money.”
