How do you invest savings for short-term, medium-term, and long-term goals? There are almost as many different answers to that question as there are definitions of these terms. But are we even starting with the right question?
At its core, the question of how to invest over different lengths of time is really a question of whether to invest your savings in securities like stocks and bonds or deposit it at a bank or credit union. Knowing when you would likely sell those securities or withdraw your cash deposits is only a piece of the puzzle. You also want to consider what risks are involved over that period of time and whether they can be sufficiently managed.
Investing Is Risky – But So Is Not Investing
Investing is a way to manage risk. Generally, you invest your money to grow its value. More specifically, you invest because if you don’t, your money will eventually lose value because of inflation.
Historically, prices for goods and services have doubled about once per generation. At that rate, two generations from now, people may be paying four times as much as you might pay now for those same goods and services because prices would double twice. Can you imagine paying $20 for a gallon of milk? That’s what you could be paying by the time you’re retired.
We can guard against this inflation monster by investing in the stock market. To invest in the stock market is to invest in companies. We can trust the value of companies to grow over time because, in aggregate, they’re profitable even after taking inflation into account. The profits are then either distributed to investors or retained by the company, adding to the company’s potential value.
This profitability of companies is the reason the market goes up over time – not because it has in the past. But that doesn’t mean that market values of companies will go up every year, even when profitable, because value is impacted by how much faster or slower investors collectively foresee future growth.
Inflation Is Scary – But So Is Investing
Investing in the stock market can be scary because it’s a market. Investors collectively establish prices by trying to value a massive collection of companies based on their growth potential, and they often get it wrong. But how do we know prices are wrong? Basically, they’re constantly changing or “correcting.”
When the market goes up, it’s because buyers and sellers of stock have decided the previous prices were too low and should be worth more. When the market goes down, it’s because buyers and sellers of stock have decided the previous prices were too high and should be worth less. These are corrections. It’s a never ending process of valuing companies. That’s the market monster.
But the bite is scarier than the bark.
While the volatility of investments you own can be scary, much of that is simply noise that can safely be ignored.
The real risk lies in whether you overpaid when you bought and whether you will be underpaid when you sell.
Since no one knows what the market will do next, you can’t ignore the fact that investments are either overvalued or undervalued at the time they’re made. To further complicate matters, investors don’t know by how much they are off the mark at the time the investment is made.
Granted, many investors have opinions or suspicions, but they can’t know with certainty and don’t all agree with each other. So, at the time you actually buy the investment, you may be getting a bad deal by overpaying, possibly significantly, or you might be getting a good deal by underpaying, possibly significantly.
It’s a question of good timing or bad timing, but at the moment you invest in stock, the answer doesn’t exist yet. There is no way to truly know if it’s a bad or not. Thankfully you can mitigate your risk of unlucky timing by buying at different times.
Taming the Market Monster
Thankfully, you don’t have to rely on a single purchase and a single sale in the hopes of getting a fair price. You can invest your money as you earn it during your working years. Then, when you stop working, you can sell of your investments and use the proceeds to supplement your income. This results in dollar cost averaging, which means your average is closer to the correct price of the stock you buy since you bought some too high and some too low.
When spread out across multiple market cycles, this averaging effect reduces the risk of buying high and selling low. It’s not that you’re making sure you don’t sell for less than you paid. What it means is you’re ensuring your average dollar grows at rate faster than inflation – even if it turns out that you did occasionally buy at the wrong time.
Pick Your Monster
Returning to question at hand, when should you invest in the markets and face the market monster, and when do you keep it in cash where the inflation monster can get to it? The answer depends on which monster presents the greater threat to those dollars.
The longer you keep cash, the bigger the inflation monster gets. But the longer you can dollar cost average, the smaller the market monster becomes. So, if at some point the growing inflation monster will pose more of a risk to funding a goal than a shrinking market monster, those dollars should be invested. If they won’t make it to that point, keep them in cash.
Practically speaking, if you’re talking about months or years, cash deposits in a savings account or certificates of deposit are probably the best place for your savings. If you’re talking about spanning decades, the way retirement does, you’re probably better off investing for that goal. That’s about as specific as we can get with something so uncertain.
Image Credit: Andrew Coelho