One overlooked part of all financial plans is medium term investments. When you’re young investing for retirement is simple. Just ride out the stock market for 30 or 40 years. For goals 2-5 years away, like buying a house or paying for a wedding, there are many new variables you have to deal with.
This is the Part-1 in a two part series, that will breakdown the most efficient and effective way to reach your medium term goals.
Medium vs Long Term Investments
The goal of retirement investing for someone in their 20′s is long-term growth. Short-term fluctuations will not matter if you’re not selling until 30-40 years down the road.
Medium-term investing, or investments for goals between 2-5 years away, bring different challenges. Not only do you want growth but stability is now important. Since your target is fast approaching, a down year in the market will substantially affect your goals.
Imagine, there was no such thing as risk. Investing would be simple. If you were saving and had the choice to put your money in a savings account which will earn 3% guaranteed or a bond fund earning 6% guaranteed, which investment would you choose? If there was no risk and each investment was guaranteed, the obvious choice is the bond fund.
I’m sorry to tell you that there is such a thing as risk. Your goal, as an investor, is to get the highest reward for the least amount of risk . You’re never going to eliminate risk. However, controlling risk by understanding types of risk you’re investment is subjected to is possible.
Medium Term Investing In the Stock Market
Here are a few numbers to consider:
-38, -22, -12, 32, 33, 38
Those are the three worst and the three best years the S&P 500 has had since 1980.
No one can tell you what the S&P 500 index will be worth in a 1 year from now. The range of returns of the S&P 500 index is fairly large. That unpredictability, makes for a terrible investment for goals less than 5 years away.
For closer goals, you’re going to give up the chance to earn 38% a year, but also give up the chance to lose 38% a year.
Types of Risk
Behavior Risk
By understanding risk, you can minimize risk because the biggest risk you have is your behavior.
As investors, we make terrible decisions. A great experiment conducted by Dalbar Inc. The study, conducted over a 17 year period, showed the difference between what the market earned and what investors earned. In the 17 years that Dalbar conducted the study, the S&P 500 earned 16.29% a year. Even with the S&P 500 having a successful run, the average equity fund investor earned just 5.32%.
The average investor’s behavior caused them to lag about 11% behind a simple index fund. I wouldn’t be surprised if this lag grows even larger in the future. In February of this year,many investors were bailing out of the market. They said they couldn’t handle anymore loss. However, by not hanging on for a few more months, this is what they have missed:
- March 09 = 8.54%
- April 09 = 7.41%
- May 09 = 5.31%
- June 09 = .02
- July 09 = 7.41%
- August = 3.36%
The best part is, the investors that sold in February, are now contemplating buying the same exact investment they had, at about 40% higher than what they sold it for. In any other area of our life, does this sound logical?
You can save yourself a lot of time and money, by being aware of your irrational behavior.
Inflation Risk
The next risk you need to be aware of is inflation risk or the risk that your investment will not keep pace with inflation, which will shrink the real value of investment.
Medium term investors are subject to inflation risk. For example, if you’re saving for a house down payment and set a goal to have 20% or $60,000 down for a $300,000 home. However, for the next 5 years, home prices rise 10% a year. Your original goal of having $60,000 for a 20% down payment will still buy you a $300,000 house, just not the house you thought you could afford.
The better option is to assume home prices will rise the next 5 years and insert that into your calculation.
Interest Rate Risk
Shorter and medium term investments are subject to interest rate risk. As interest rates rise and fall, certain investments have different reactions.
Generally, as interest rates rise, bond prices will lower. For example, you purchased a bond from Corporation A two years ago with a ten year term that paid 6%, Today, because of the rise in interest rates, Corporation A is issuing a ten-year term bond with an 8% interest rate. Do you think there will be people wanting to pay a premium to buy your bond you bought 2 years ago that pays 6%, when they can buy a bond today that pays 8%. Inversely, if interest rates fell, and Corporation A, is now issuing 4% bonds, people would be willing to pay a premium for a bond that pays 6% instead of 4%.
To reduce interest rate risk, you can invest in shorter-term bonds. In the example above, Corporation A’s bond matured in 10 years. Instead what if they only issued a bond that matured in less than a year. A change in interest rates would have little effect for a bond maturing so soon.
Continue to Part # 2 of Medium Term Investing
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