The worst thing you can have in your long-term investment portfolio is a big pot of cash
Everyone needs a pool of cash as a component of their financial holdings, but most people end up with way more cash than they need in their portfolio. Your family has three needs for cash investments: (1) Emergency fund (2) This month's bills (3) Savings for this year's large expenses. Beyond that, cash isn't generally a good investment to hold.
The Purpose of Cash
Cash investment instruments include savings accounts, certificates of deposit, money market accounts, and checking accounts. Their purpose is to provide you with quick access to a pool of risk-free money. Cash investments are wonderful short-term savings tools and provide protection against losses in value, but over longer periods, cash carries a much bigger risk.
The Problem With Cash
Over periods of one year or more, the real danger for cash investments is the investment not keeping up with inflation. Although your savings account might provide you 0.1% to 1% return, the average long-term inflation rate is over 3%. Inflation means, on a real basis, you are losing up to 2% of your money every year in your supposedly 'safe' savings account.
Simply put, cash doesn't grow, and when adjusted for inflation, you actually lose money.
Few non-retirees carry cash in retirement accounts because of the long-term nature of retirement investing. But many people still invest in cash for medium-term investing such as buying a car in three years, taking a vacation in five years, or building a down payment for a home purchase in ten years. Using cash investment instruments to save for these types of goals will not only keep your money from growing, but will actually cause you to lose ground due to inflation.
Diversify Out of Cash
You should regularly review the savings that you have and determine what specifically you are saving each 'pool' of money for. Then, determine the time frame for each pool of money. Any savings effort where the purpose of the money is to purchase something more than a year in the future should not be left in cash.
Instead you want to diversify those investments out of cash and into more appropriate long-term investment vehicles. The type of vehicle that you choose will be determined by how far in the future you plan to use the money and your personal risk tolerance.
1 - 3 Years
Investments that you plan to use within the next one to three years should be invested in very low risk investments. Because of the short time frame, the amount of risk you can take on will be limited. If the market were to drop dramatically in year two of the investment period, there won't be enough time for the investment to recover before you need the money.
Low & Moderate Risk Tolerance
If you have a low risk tolerance you should be looking at certificates of deposit and United States Treasury instruments. Those with a more moderate risk tolerance can look at investment-grade bonds, municipal bonds, and funds that invest in bonds as an appropriate investment vehicle. These are very low-risk investments and unlikely to drop in value. Investing directly in the bonds that mature when you need the money will further reduce your risk, as bond funds can drop in value when interest rates rise.
High Risk Tolerance
If you have a higher risk tolerance, a solid balanced mutual fund or ETF can provide you with slightly greater return from stocks while the bonds reduce the volatility. Look for a fund with a heavy exposure to investment-grade bonds as well as some exposure to equities. Balanced funds can provide you with a slightly greater return from the stocks while the bonds will help to lessen the potential downturn downside loss
3 - 5 Years
Over a three- to five-year investment timeline, you should diversify out of cash and into investments that have slightly higher risk and slightly greater potential for return.
Low & Moderate Risk Tolerance
Families with a low risk tolerance will want to focus on investment-grade bonds, municipal bonds, and bond funds. These provide very safe investments and are unlikely to significantly depreciate in value unless you're in a rising interest-rate environment. If you expect interest rates to be rising in the future over the investment timeline, you will want to invest in shorter-term bonds of less than five years to minimize the potential volatility that could come with interest rate increases. Those with a moderate risk tolerance should look toward the 1-3 year high risk tolerance investments: solid balanced funds that invests in a diversified portfolio of stocks and investment-grade corporate and government bonds.
High Risk Tolerance
If you have a higher risk tolerance, a broadly diversified stock fund or a large-cap index fund can provide you with greater growth potential, although it will also have higher volatility. Fortunately, with a 3 to 5 year time horizon, it will be highly likely that a market crash would be recovered before you have need of the money. On average, market declines last for 14 months, with the longest one in history lasting slightly less than 2.5 years.
5-10 years
For pools of money that you still have 5 to 10 years before you'll need the money, you will want to take on much greater risk in order to allow that money to grow. With 5 to 10 years before you need the money, it will be very easy to wait for a market to recover if your investments lose value.
Low & Moderate Risk Tolerance
Low risk-tolerance investors should be looking at balanced mutual funds or asset allocation funds with long track records. Moderate-risk investors should look to large-cap index funds and broadly diversified mutual funds. Large-cap corporations are much less likely to have significant volatility than smaller companies, although all stocks have market risk.
High Risk Tolerance
Families with a higher tolerance for risk may look to increase their growth potential by investing in slightly riskier mid-cap and small-cap index funds. The companies these funds invest in, being smaller than the large-cap companies, have an easier time growing, but have a higher likelihood of declining sales or going out of business. For example, it is relatively easy for a company like Tesla to double their sales due to the fact that they don't sell very many cars compared to Ford. At the same time, it is much more likely that Tesla will go out of business then will Ford.
10+ years
If you are investing for a time period of greater than 10 years, taking on more risk should be your mantra. At this time frame, the risk of not growing your money is greater than the potential risk of a short-term market downturn.
Low & Moderate Risk Tolerance
Individuals with low risk tolerance should be looking to invest in large-cap index and mutual funds. They provide significantly greater growth opportunities for this pool of money while still keeping risk at a comfortable level. Those with moderate risk tolerances should look toward mid-cap index funds and maybe even include some small-cap funds.
High Risk Tolerance
If you have a high tolerance for risk, with 10+ years to invest you can look toward significantly riskier investments in order to increase your returns. You may look at small-cap funds, high-yield bond funds, emerging market international funds or any other investments.
Maintaining a Broad Asset Allocation
The assumption here is that you are investing for multiple goals in your life with multiple time frames. As a result, you will have a diverse asset allocation when you look at your investment portfolio as a whole. Some of your investments (the ones for long-term goals) will be very risky and include small-cap and emerging market funds. At the same time, however, some of your money will be invested for a goal that is only a few years away, requiring bonds and other low-risk investments in your total portfolio.
Diversifying Back to Cash
Just like you should be diversifying away from cash for pools of money that are invested for further out in the future, as those dates approach you should be diversifying back into safer investments. You may start with an investment regime that is very risky for the pool of money you are you planning to use for a down payment on a house 12 years into the future.
A few years later, however, that money should be taken out of riskier investments should be reinvested in investment vehicles appropriate to the new time frame. As time continues to move on, you should continually be ratcheting down the risk on the pool of money as you approach the achievement of your goal.
As you come into the last year or two of the investment, you should be diversifying the entire investment back into cash to avoid losses in the final year before you need the money.
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