Eric Tyson - Investing For Dummies

Another place to keep your liquid savings is in a money market mutual fund. These are the safest types of mutual funds around and, for all intents and purposes, equal a bank savings account’s safety. The best money market funds generally pay higher yields than most bank savings accounts. Unlike a bank, money market mutual funds tell you how much they deduct for the service of managing your money. If you’re in a higher tax bracket, tax-free versions of money market funds exist as well. See Chapter 8for more on money market funds.

If you don’t need immediate access to your money, consider using Treasury bills (T-bills) or bank certificates of deposit (CDs), which are usually issued for terms such as 3, 6, or 12 months. Your money will generally earn more in one of these vehicles than in a bank savings account. (In recent years, the yields on T-bills has been so low that the best FDIC-insured bank savings accounts have higher yields.) Rates vary by institution, so it’s essential to shop around. The drawback to T-bills and bank certificates of deposit is that you generally incur a penalty (with CDs) or a transaction fee (with T-bills) if you withdraw your investment before the term expires (see Chapter 7).

When you buy a bond, you lend your money to the issuer of that bond (borrower), which is generally a government or a corporation, for a specific period of time. When you buy a bond, you expect to earn a higher yield than you can with a money market or savings account. You’re taking more risk, after all. Companies can and do go bankrupt, in which case you may lose some or all of your investment.

Generally, you can expect to earn a higher yield when you buy bonds that

Are issued for a longer term: The bond issuer is tying up your money at a fixed rate for a longer period of time.

Have lower credit quality: The bond issuer may not be able to repay the principal.

Wharton School of Business professor Jeremy Siegel has tracked the performance of bonds and stocks back to 1802. Although you may say that what happened in the 19th century has little relevance to the financial markets and economy of today, the decades since the Great Depression, which most other return data track, are a relatively small slice of time. Figure 2-4 presents the data, so if you’d like to give more emphasis to the recent numbers, you may.

Note that although the rate of inflation has increased since the Great Depression, bond returns haven’t increased over the decades. Long-term bonds maintained slightly higher returns in recent years than short-term bonds. The bottom line: Bond investors typically earn about 4 to 5 percent per year.

© John Wiley & Sons, Inc.

FIGURE 2-4:A historical view of bond performance: Inflation has eroded bond returns more in recent decades.

Investors expect a fair return on their stock investments. If one investment doesn’t offer a seemingly high enough potential rate of return, investors can choose to move their money into other investments that they believe will perform better. Instead of buying a diversified basket of stocks and holding, some investors frequently buy and sell, hoping to cash in on the latest hot investment. This tactic seldom works in the long run.

Unfortunately, some of these investors use a rearview mirror when they purchase their stocks, chasing after investments that have recently performed strongly on the assumption (and the hope) that those investments will continue to earn good returns. But chasing after the strongest performing investments can be dangerous if you catch the stock at its peak, ready to begin a downward spiral. You may have heard that the goal of investing is to buy low and sell high. Chasing high-flying investments can lead you to buy high, with the prospect of having to sell low if the stock runs out of steam. Even though stocks as a whole have proved to be a good long-term investment, picking individual stocks is a risky endeavor. See Chapters 5and 6for my advice on making sound stock investment decisions.

A tremendous amount of data exists regarding stock market returns. In fact, in the U.S. markets, data going back more than two centuries document the fact that stocks have been a terrific long-term investment. The long-term returns from stocks that investors have enjoyed, and continue to enjoy, have been remarkably constant from one generation to the next.

Going all the way back to 1802, the U.S. stock market has produced an annual return of 8.3 percent, while inflation has grown at 1.4 percent per year. Thus, after subtracting for inflation, stocks have appreciated about 6.9 percent faster annually than the rate of inflation. The U.S. stock market returns have consistently and substantially beaten the rate of inflation over the years (see Figure 2-5).

© John Wiley & Sons, Inc.

FIGURE 2-5:History shows that stocks have been a consistent long-term winner.

Stocks don’t exist only in the United States, of course (see Figure 2-6). More than a few U.S. investors seem to forget this fact, as they did during the sizzling performance of the U.S. stock market during the late 1990s and 2010s. As I discuss in the earlier section “ Diversify for a smoother ride,” one advantage of buying and holding overseas stocks is that they don’t always move in tandem with U.S. stocks. As a result, overseas stocks help diversify your portfolio.

In addition to enabling U.S. investors to diversify, investing overseas has proved to be profitable. The investment banking firm Morgan Stanley tracks the performance of stocks in both economically established countries and so-called emerging economies. As the name suggests, countries with emerging economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, and Taiwan) are “behind” economically but show high growth and progress rates.

Stocks are the best long-term performers, but they have more volatility than bonds and Treasury bills. A balanced portfolio gets you most of the long-term returns of stocks without much of the volatility.

© John Wiley & Sons, Inc.

FIGURE 2-6:Plenty of investing opportunities exist outside the United States.

Over the years, real estate has proved to be about as lucrative as investing in the stock market. Whenever the U.S. has a real estate downturn, folks question this historic fact (see Chapter 11for details). However, just as stock prices have down periods, so, too, do real estate markets.

The fact that real estate offers solid long-term returns makes sense because growth in the economy, in jobs, and in population ultimately fuels the demand for real estate.