20 questions, No. 3: Big question in tough times: How do I protect my money?
THE SAVAGE TRUTH | Treasury bills good for short-term purposes, but stocks are proven to beat inflation over time
Question: How can I avoid risk with my money? That's a question being asked more and more these days, as investors watch their investment accounts dwindle in a bear market. Suddenly, a stock market that seemed like a "sure thing" has turned on investors, demonstrating that money can disappear almost overnight.
In fact, the same thing has happened with residential real estate. The sure "road to riches" has disappeared over a cliff. Homes that were supposed to increase in value are now worth less than the purchase price, and often worth less than the amount of the mortgage.
(AP)
Sure, you still own the shares of stock, and you still live in your home, but they're simply worth less money today. If you weren't planning to sell the home for a while, and if you weren't planning to draw on your retirement funds for years, you certainly stand a good chance of getting even or even ahead in the years to come. It all depends on your time horizon.
So if by "avoiding risk" you mean avoiding the possibility of losing money, you'll have to specify a time frame in order to get a meaningful answer to your question!
Will you need the money next week, next month, within a year, or even within five years? That's what I call "chicken money" -- money you can't afford to lose. So it belongs in safe, liquid, insured investments.
This low-risk money belongs in an FDIC-insured money market deposit account at your bank. Or in short-term government IOUs, such as Treasury bills, which are easily purchased online at www.TreasuryDirect.gov, with a $100 minimum. Or you could put your cash in a Treasury-only money market mutual fund.
The only drawback to these alternatives is that they pay a very low rate of interest these days. But, of course, you know the motto of the chicken money investor: "I'm not so concerned about the return ON my money as I am about the return OF my money!"
Even if you keep your money stashed in these safe places, you're still exposed to a risk -- the risk that inflation will destroy the spending power of the money you've saved.
The "Rule of 72" tells us that if you divide any number into 72, the result will be the amount of time it takes for your money to be cut in half by inflation. For example, at a 7 percent annual rate of inflation, your spending power will be cut in half in 10 years!
Knowing that, you start to think about putting at least part of your savings in a place that has a long-term track record of beating inflation. And that brings you right back to the stock market!
Over the long run -- at least 20 years -- a diversified portfolio of large company American stocks (such as the S&P 500), sheltered from taxes (inside a retirement account), with dividends reinvested, has always beaten inflation, according to Ibbotson, the market historians. Their studies include every 20-year period starting in 1926.
So before you walk away from that "risky" stock portfolio, you might want to consider the stock market's past track record of protecting you from the risk of inflation. Of course, past performance is no guarantee of future results. But if you're worried that this 20-year period will be "different," you're really saying that you're worried about the future of America. And in that case, your true risk is greater than your financial balance sheet!
It's impossible to completely eliminate risk in life -- or in money management. We take a risk when we walk out the door, get on the bus, or eat lunch! In money management, as in life, the critical task is to understand the nature of the risk, weigh the probabilities, and then balance all of the risks so you can enjoy today and have the best chances for enjoying tomorrow.
Life doesn't come with any guarantees. Neither does money. And that's The Savage Truth.