Why should you invest?
For people with money in the market, the first answer might be, “To make money.” But that’s not exactly right.
The real goal of investing is to pay for some obligation more than five years into the future. Typically, that means retirement, but it could also be another long-term goal, such as college savings.
Staying ahead of inflation is one big reason to invest. For the past several years, inflation has been low, but that will change. Investors who are sitting on a pile of cash will find spending power eroded, which is a bigger problem than it may seem, particularly if you are facing retirement without a paycheck from a job.
Historically, stocks have been a tried-and-true vehicle to outpace inflation. They also have the advantage of liquidity — something real estate or other investments, such as art, usually can’t match.
The question of why to invest is not the only one you should ask. Here are other questions pre-retirees would be wise to consider:
•How do I envision my future? This is a little different from an investing goal, in that it requires you to imagine your best future. Studies have shown that it’s difficult for the human brain to imagine ourselves more than five years into the future, and a one-to-two-year time frame is even more doable.
Sure, we all need to take steps today to ensure our security and happiness off into the distance, but even if you imagine yourself in two years, how does your money fit into the picture? Do you have a comfortable nest egg? Can you easily afford a comfortable lifestyle, without worries about debt or paying monthly bills?
•What are the risks of my current investments? Every investment carries risk, but some carry more than others. A single stock, for example, is one of the riskiest securities you can hold, even if it’s a “blue chip,” or something your parents passed down to you.
Many people remember the Enron debacle of 2001, but I have a more personal story. My father worked for Eastman Kodak for 31 years. The company had a slow and painful failure, with management in denial as digital technologies gradually eclipsed film. The company’s stock was removed from the Dow Jones Industrial Average, and later from the Standard & Poor’s 500 Index. Kodak filed for Chapter 11 bankruptcy protection in 2012 and emerged in 2013.
The company is a shadow of its former self. For investors who believed Kodak was a “safe” investment, a basic index fund of large American companies would have smoothed that single-stock risk.
Even better, use broad diversification into funds representing companies from around the world, including small and large firms. Add some high-quality bonds, keeping the term-to-maturity on the short or intermediate side. These are proven ways to mitigate risk when a single company goes through hard times.
•How much do you expect this investment to return? Any given portfolio has an expected return. This is based on historical returns of that portfolio, internal costs and risks inherent in the investment mix.
Unfortunately, many investors don’t understand this and believe every portfolio should have an eye-popping double-digit return every year, or something is seriously wrong.
It doesn’t work that way. A properly allocated portfolio typically has a return somewhere in the single digits, depending on how much risk you take. That risk should be appropriate to your goals and situation, not just because you feel like a market daredevil. While returns of 4 percent, 5 percent, 6 percent or 7 percent don’t feel as exciting as a single stock whose value can, in fact, jump by double or triple digits, remember those risk levels. Also, don’t forget the magic of compounding: That 5 percent gain will compound over time.
Sure, you’ll have years of losses. That’s normal. But you’ll also have years when your portfolio returns more than its expected amount. That’s also normal.
The key to investing is understanding what you own, why you own it, and what it’s designed to do.
Kate Stalter, founder of the independent firm Better Money Decisions, helps people throughout Northern New Mexico invest and plan for retirement. For a free report, “7 Warning Signs You Are Working With The Wrong Advisor,” email WeCanHelp@BetterMoneyDecisions.com.