Each day you hold onto dollars, you become poorer. Over time, inflation destroys the purchasing power of your savings. A dollar today might be worth only $.70 in purchasing power a decade from today.
Understanding investment risk
There is no way to make a risk-free profit. By definition, investments have two sources of returns: inflation and risk. Thus, a risk-free opportunity like a certificate of deposit or US Treasury bill or bond should provide a return equal to the inflation rate. There is no risk to a US Treasury bill or bond, or a FDIC-insured certificate of deposit. In the worst case, you will get your dollars back because the US government will take to the printing presses to make you equal.
Theoretically, there is some risk to the safest investments. If you buy a certificate of deposit and earn 1% per year for 5 years, the risk is that your savings will not grow fast enough to keep up with inflation. Likewise, there is a risk that you won’t be able to save enough for a big purchase or a future retirement lifestyle.
How much risk should you take?
The best time to take a risk is when you’re young, dumb, and invincible. You can easily make up for a loss in your twenties. You cannot make up for losses so easily when you are 70 years old, fragile, and thinking about a life without work.
Risk is measured by how volatile a portfolio is. A portfolio of 100% CD investments will have zero volatility. However, a portfolio of 100% CDs will only reward you with very small, single digit returns. After inflation, you’ll likely lose purchasing power each year.
In the same way, a portfolio of 100% stocks is much riskier as the stock market is volatile. Stocks rise and fall in value by 1% or more from day to day. However, in the long run, a portfolio of 100% stocks provides the highest returns.
Investors should seek to find balance between risk and reward. Here’s a good starting portfolio for a young investor:
60% American stocks – The American stock market is the largest in the world. U.S.-based companies make money domestically by selling goods and services to Americans, but they also have exposure to the international markets. General Motors is an all-American company bought and sold on American exchanges, but it makes cars in Europe, Asia, and South America. One of the best ways to invest in the American stock market is to buy a fund like the Vanguard Total Stock Market Index Fund (VTSMX), which invests in every single investable stock on American exchanges.
20% International stocks – International markets are the riskiest investments as they include up and coming emerging markets with less stable governments and financial markets. However, diversified investors will want some exposure to international opportunities. A fund like the Vanguard FTSE All-World ex-US Index Fund (VFWIX) will put investors right in the mix for international stocks.
20% bonds – Bonds are not the kind of investment that will make you rich, especially since 10-year US Treasury bonds yield less than 2%. Bonds are meant as a safety net to avoid the risk of buying high and selling low. When you rebalance your portfolio, which you should do annually, you’ll sell stocks and buy bonds when stocks rise. When stocks fall, you’ll be selling bonds and buying stocks. Thus, bonds act as a mechanism for avoiding large-scale investment losses. Consider a fund like the Vanguard Intermediate-Term Bond Index (VBIIX), which holds bonds spanning 5-10 years.
Rebalancing and diversification
The example portfolio above would leave you owning more than 5500 stocks and 1400 bonds, despite the fact you’d own only three different funds.
The key to the portfolio is rebalancing your investments once per year, locking in profits in the parts of your portfolio with runaway success and adding to investments that have become relatively cheaper during the year.
Ultimately, though, the goal of an investment plan is to build your net worth. The youngest of investors with student loan debt or high interest consumer debt can replace their bond exposure with faster prepayments on their debt loads. It makes very little sense to borrow with student loans at 6.2% and invest in bonds that yield 1-4% per year. Your debt would make for a better investment.
As 20-somethings build wealth, alternative investments like real estate begin to make sense for more diversification and income. Compared to the easy come, easy go investment opportunities in stocks and bonds, real estate and alternatives make good investments when your portfolio has grown to support more diversification.
As a starter portfolio, a three fund portfolio of American and international stocks and a small position in bonds will give you a great starter portfolio with broad diversification and a balanced risk-profile.