Economy and Kids!

Determine Your Risk Tolerance

• Savings
• Investing
• Diversification
• Risk Tolerance

You are approaching the half-way point in your journey to saving and investing. This is a good point to make sure that you understand some key concepts:

Savings

Your "savings" are usually put into the safest places or products that allow you access to your money at any time. Examples include savings accounts, checking accounts, and certificates of deposit. At some banks and savings and loan associations your deposits may be insured by the Federal Deposit Insurance Corporation (FDIC). But there's a tradeoff for security and ready availability. Your money is paid a low wage as it works for you. 

Most smart investors put enough money in a savings product to cover an emergency, like sudden unemployment. Some make sure they have up to 6 months of their income in savings so that they know it will absolutely be there for them when they need it.

But how "safe" is a savings account if you leave all your money there for a long time, and the interest it earns doesn't keep up with inflation? Let’s say you save a dollar when it can buy a loaf of bread. But years later when you withdraw that dollar plus the interest you earned, it might only be able to buy half a loaf. That is why many people put some of their money in savings, but look to investing so they can earn more over long periods of time, say three years or longer.

Investing

When you "invest," you have a greater chance of losing your money than when you "save." Unlike FDIC-insured deposits, the money you invest in securities, mutual funds, and other similar investments are not federally insured. You could lose your "principal," which is the amount you've invested. That’s true even if you purchase your investments through a bank. But when you invest, you also have the opportunity to earn more money than when you save.

But what about risk? All investments involve taking on risk. It’s important that you go into any investment in stocks, bonds or mutual funds with a full understanding that you could lose some or all of your money in any one investment. While over the long term the stock market has historically provided around 10% annual returns (closer to 6% or 7% “real” returns when you subtract for the effects of inflation), the long term does sometimes take a rather long, long time to play out. Those who invested all of their money in the stock market at its peak in 1929 (before the stock market crash) would wait over 20 years to see the stock market return to the same level. However, those that kept adding money to the market throughout that time would have done very well for themselves, as the lower cost of stocks in the 1930s made for some hefty gains for those who bought and held over the course of the next twenty years or more.

Diversification

It is true that the greater the risk, the greater the potential rewards in investing, but taking on unnecessary risk is often avoidable. Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called “diversification,” can be neatly summed up as, “Don’t put all your eggs in one basket.” Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929) by following a consistent pattern of adding new money to their investments over long periods of time.

Once you’ve saved money for investing, consider carefully all your options and think about what diversification strategy makes sense for you. While the SEC cannot recommend any particular investment product, you should know that a vast array of investment products exists—including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, certificates of deposit, money market funds, and U.S. Treasury securities. Diversification can’t guarantee that your investments won’t suffer if the market drops. But it can improve the chances that you won’t lose money, or that if you do, it won’t be as much as if you weren’t diversified.

Risk Tolerance

What are the best saving and investing products for you? The answer depends on when you will need the money, your goals, and if you will be able to sleep at night if you purchase a risky investment where you could lose your principal.

For instance, if you are saving for retirement, and you have 35 years before you retire, you may want to consider riskier investment products, knowing that if you stick to only the "savings" products or to less risky investment products, your money will grow too slowly—or given inflation or taxes, you may lose the purchasing power of your money. A frequent mistake people make is putting money they will not need for a very long time in investments that pay a low amount of interest.

On the other hand, if you are saving for a short-term goal, five years or less, you don't want to choose risky investments, because when it's time to sell, you may have to take a loss. Since investments often move up and down in value rapidly, you want to make sure that you can wait and sell at the best possible time.

Investment Products

Your Choices

• Stocks and Bonds
• Mutual Funds

When you make an investment, you are giving your money to a company or an enterprise, hoping that it will be successful and pay you back with even more money.

Some investments make money, and some don’t. You can potentially make money in an investment if:

• The company performs better than its competitors.
• Other investors recognize it’s a good company, so that when it comes time to sell your investment, others want to buy it.
• The company makes profits, meaning they make enough money to pay you interest for your bond, or maybe dividends on your stock.

You can lose money if:

• The company’s competitors are better than it is.
• Consumers don’t want to buy the company’s products or services.
• The company’s officers fail at managing the business well, they spend too much money, and their expenses are larger than their profits.
• Other investors that you would need to sell to think the company’s stock is too expensive given its performance and future outlook.
• The people running the company are dishonest. They use your money to buy homes, clothes, and vacations, instead of using your money on the business.
• They lie about any aspect of the business: claim past or future profits that do not exist, claim it has contracts to sell its products when it doesn’t, or make up fake numbers on their finances to dupe investors.
• The brokers who sell the company’s stock manipulate the price so that it doesn’t reflect the true value of the company. After they pump up the price, these brokers dump the stock, the price falls, and investors lose their money.
• For whatever reason, you have to sell your investment when the market is down.

Here are some kinds of investments you may consider making:

Stocks and Bonds

Many companies offer investors the opportunity to buy either stocks or bonds. The following example shows you how stocks and bonds differ.

Let’s say you believe that a company that makes automobiles may be a good investment. Everyone you know is buying one of its cars, and your friends report that the company’s cars rarely break down and run well for years. You either have an investment professional investigate the company and read as much as possible about it, or you do it yourself.

After your research, you’re convinced it’s a solid company that will sell many more cars in the years ahead. The automobile company offers both stocks and bonds. With the bonds, the company agrees to pay you back your initial investment in ten years, plus pay you interest twice a year at the rate of 8% a year.

If you buy the stock, you take on the risk of potentially losing a portion or all of your initial investment if the company does poorly or the stock market drops in value. But you also may see the stock increase in value beyond what you could earn from the bonds. If you buy the stock, you become an “owner” of the company.

You wrestle with the decision. If you buy the bonds, you will get your money back plus the 8% interest a year. And you think the company will be able to honor its promise to you on the bonds because it has been in business for many years and doesn’t look like it could go bankrupt. The company has a long history of making cars and you know that its stock has gone up in price by an average of 9% a year, plus it has typically paid stockholders a dividend of 3% from its profits each year.

You take your time and make a careful decision. Only time will tell if you made the right choice. You’ll keep a close eye on the company and keep the stock as long as the company keeps selling a quality car that consumers want to drive, and it can make an acceptable profit from its sales.

Mutual Funds

Because it is sometimes hard for investors to become experts on various businesses—for example, what are the best steel, automobile, or telephone companies—investors often depend on professionals who are trained to investigate companies and recommend companies that are likely to succeed.

Since it takes work to pick the stocks or bonds of the companies that have the best chance to do well in the future, many investors choose to invest in mutual funds.

What is a mutual fund?

A mutual fund is a pool of money run by a professional or group of professionals called the “investment adviser.” In a managed mutual fund, after investigating the prospects of many companies, the fund’s investment adviser will pick the stocks or bonds of companies and put them into a fund. Investors can buy shares of the fund, and their shares rise or fall in value as the values of the stocks and bonds in the fund rise and fall.

Investors may typically pay a fee when they buy or sell their shares in the fund, and those fees in part pay the salaries and expenses of the professionals who manage the fund.

Even small fees can and do add up and eat into a significant chunk of the returns a mutual fund is likely to produce, so you need to look carefully at how much a fund costs and think about how much it will cost you over the amount of time you plan to own its shares. If two funds are similar in every way except that one charges a higher fee than the other, you’ll make more money by choosing the fund with the lower annual costs. To easily compare mutual fund costs, you can use our mutual fund cost calculator.

Mutual Funds Without Active Management

One way that investors can obtain for themselves nearly the full returns of the market is to invest in an “index fund.” This is a mutual fund that does not attempt to pick and choose stocks of individual companies based upon the research of the mutual fund managers or to try to time the market’s movements. An index fund seeks to equal the returns of a major stock index, such as the Standard & Poor 500, the Wilshire 5000, or the Russell 3000. Through computer programmed buying and selling, an index fund tracks the holdings of a chosen index, and so shows the same returns as an index minus, of course, the annual fees involved in running the fund. The fees for index mutual funds generally are much lower than the fees for managed mutual funds.

Historical data shows that index funds have, primarily because of their lower fees, enjoyed higher returns than the average managed mutual fund. But, like any investment, index funds involve risk.

Watch "Turnover" to Avoid Paying Excess Taxes

To maximize your mutual fund returns, or any investment returns, know the effect that taxes can have on what actually ends up in your pocket. Mutual funds that trade quickly in and out of stocks will have what is known as “high turnover.” While selling a stock that has moved up in price does lock in a profit for the fund, this is a profit for which taxes have to be paid. Turnover in a fund creates taxable capital gains, which are paid by the mutual fund shareholders.

The SEC requires all mutual funds to show both their before- and after-tax returns. The differences between what a fund is reportedly earning, and what a fund is earning after taxes are paid on the dividends and capital gains, can be quite striking. If you plan to hold mutual funds in a taxable account, be sure to check out these historical returns in the mutual fund prospectus to see what kind of taxes you might be likely to incur.

For more information about mutual funds, please read our publication Invest Wisely: An Introduction to Mutual Funds.

Do you need a professional guide to help you complete your saving and investing journey? To answer that question, take the next step to explore the issue of "How to Pick a Financial Professional."