The risks of riskless investing.
After experiencing volatility in stocks and real estate during this century, some people are reluctant to take risks with their money. However, when you avoid risk, you also reduce your chance of enjoying portfolio growth.
U.S. Treasury bills are considered a nearly risk-free investment. If you put money into bills maturing in 30 days, you'll get a return of your capital then, plus a market interest rate. Ibbotson Associates, a Morningstar subsidiary, recently reported that $1 invested in Treasury bills at the end of 1925 would have grown to more than $20 at the end of 2013, assuming continual reinvestment of interest income. That's impressive, and it would have kept this hypothetical investor ahead of inflation: you need $13 today to buy the current equivalent of what a dollar bought in 1925.
However, these Ibbotson numbers don't take transaction costs or income taxes into effect. Over such a long term, the taxes from continual investments in Treasury bills would have depressed net returns to around, or even below, the inflation rate.
In hindsight, other investments would have produced much higher returns. Intermediate-term Treasury bonds (with maturities around five years) aren't riskless, but they are relatively low risk. Under the same assumptions (reinvested interest, no taxes or transaction costs), that dollar invested at the end of 1925 would have grown to $93 at the end of 2013. There were few yearly losses and those losses tended to be modest (Ibbotson puts the steepest calendar year loss at -2.3% in 2009).
Concurrently, $1 invested in large company U.S. stocks would have grown to more than $4,600! Some steep losses occurred during those 88 years, however, such as the 37% decline in 2008.
All of the stock and bond categories tracked by Ibbotson have handily outperformed Treasury bills--and beaten inflation--over the time period being reviewed. That doesn't mean you should avoid riskless, cash-like holdings altogether, but it does mean that taking some risks can pay off over many years. Considering today's negligible yields on low-risk vehicles, such as T-bills and money market funds and bank accounts, you'll need to take some investment risks today to get any meaningful return.
For the highest long-term return, you might consider a 100% allocation to stocks, combined with ongoing outlays in this asset class. However, few people have the temperament to buy stocks, hold them, and keep investing even in bleak times. Therefore, many professionals advocate holding a mix of investments that aren't linked to each other so that some may rise while others fall.
Example: Ibbotson shows the long-term results from various hypothetical portfolios. A 50-50 allocation, stocks to bonds, would have produced about 80% of the return of stocks with only 50% of the volatility that an all-stock portfolio would have generated. By working with a financial advisor, you may be able to develop a diversified asset allocation with an acceptable mix of risk and potential reward.
Beyond diversification, the Ibbotson results reinforce basic points about managing your money. Reinvesting interest and dividends will help you maximize your compounded returns. Similarly, making an effort to minimize taxes and transaction costs will pay off over an extended time period.