by Andrew Horowitz

I always encourage listeners and readers to send in questions about anything you hear on the Winning Investor podcast or about investing in general.   I'm happy to dedicate an episode to answering a common listener question, and this episode is designed just for that.

Gabriel from Salt Lake City asks:

“I’m a hard-working 24-year-old who has managed to save $15,000. I need to keep it in liquid because I expect to replace my car in the next 2-3 years. However, I am worried that the toll inflation takes on my savings account makes the account no better than a short-term bond fund. Of course, the bond fund might decline 1% if interest rates rise. But I know my checking account will decline 1% no matter what. Please help!”

Gabriel’s question is on the minds of many investors today who are concerned with preserving their capital and avoiding erosion by an inflation rate higher than you can get with safe investments like CDs or even some Treasury Bonds.  If you keep a sizable amount of cash safely tucked away in your checking account or very low yielding savings account, over the months and years, inflation will become more and more of a factor.  

What is Inflation?

We all want to protect our money, but as we've discussed in prior podcasts, if you are too conservative with your money, you run the risk of your savings being worth comparatively less in the future, or specifically, the price of everything money buys will rise gradually over time while your account will stay roughly the same value.

As we've mentioned before, the cost of an average new car in 1960 was around $3,000 to $4,000.  You may scoff at that value now because the cost of a new car in 2011 is around $15,000 to $20,000.  

If an investor socked away $20,000 in 1960 in a very low interest savings account and then decided to take out that money and start spending it in today's environment, it certainly wouldn't buy as many things today as it would in 1960: $20,000 in 1960 bought 5 brand-new cars, but in 2011 it would buy just one.  To drive the comparison home, a $20,000 account in 1960 was roughly equal to $100,000 in today's terms, at least when using this comparison of car prices.  

$100,000 would buy about 5 new cars today, but think about 40 years into the future when $100,000 might only buy ONE new car.  I doubt the average American in 1960 could have imagined paying $20,000 for a new car, just as you can't see yourself paying $100,000 for a new car but that's what inflation does over the years! The fact that the price of things money buys increases about 2% or more each year is the uphill battle you face as an investor - your investments must beat the rate of inflation over time or else you'll be disappointed in the future.

4 Investment Options

The general advice I'm sure you've heard time and again is that younger investors can afford to seek higher risk, higher return or yield investments because they can ride-out market volatility and continue to earn an income. On the other hand, older workers nearing retirement or already in retirement cannot afford to hold high return, high risk securities because a decline in these securities can eliminate a large portion of their account that can't be made back as easily, or at all. 

Here are the 4 investment options, in order from least to most risky:

Option #1 - On the investment continuum, cash in checking and savings accounts tends to be the most conservative place to store money. It almost by definition will never generate a return higher than the annual rate of inflation which is usually 2%.  

Option #2 - CDs are less liquid than checking and savings accounts but offer slightly higher yields.  Above that is U.S. Treasury Bonds, municipal bonds or even corporate bonds which can be bought and held to maturity.  

Option #3 - Above the bond world is the stock market in terms of risk of loss but also potential for return, including dividends on certain stocks in your portfolio.  The majority of the Winning Investor series is dedicated to building a successful portfolio so we can’t cover all options in one episode, but a stock portfolio may include a handful of carefully picked stocks or exchange-traded funds (or ETFs) which provide instant diversification.  

Option #4 - The highest risk, at least in terms of common investments, in a portfolio is the commodity world which may be accessed using commodity-based ETFs.

What Is the Rate of Return?

Just to give you some quick numbers in terms of 2010:

  • Savings and checking accounts earned less than 1%

  • Depending on maturity, CDs earned from 1% to 2%

  • Depending on when you bought it, the 10-Year U.S. Treasury Note Yield was around 3% to 3.5%

  • The S&P 500 rose about 12% in 2010 as did similar U.S. Equity Index ETFs 

  • Gold prices rose about 30%

  • Silver prices were up over 80%

  • Many other commodities returned over 50% in 2010

We certainly can’t generalize that all years will have these returns, but the main idea is that the bigger the risk you take, the bigger your potential return (and the bigger your potential loss).  

To beat the rate of inflation in 2010, an investor had to concentrate his or her portfolio with stocks and bonds, giving more weight to stocks.  Investors who took more risk by adding 5% or so of commodity-based ETFs to their portfolios most likely outperformed investors who stuck just with traditional stocks and bonds.  

The Bottom Line

So the answer to Gabriel’s important question comes back to risk and return, with the general solution being a balanced portfolio that includes bonds, stocks, and a small commodity exposure, if you're willing to take the risk.  Commodities can rise quickly but can just as easily fall, so we don't want to have our whole portfolio just in commodities or stocks.

At the same time, we don't want our whole portfolio in cash equivalents like savings and checking accounts, or even CDs unless we are retired and our top goal is preserving our wealth.  

Younger investors have time to reap the benefits of a balanced portfolio that grows steadily over the years, particularly if they contribute a portion of their income each month or each quarter. But to do so, investors need to take bigger risks to get the bigger returns outside the safety of savings accounts and CDs.  

Consider picking up a copy of my latest book The Winning Investor's Guide to Making Money in Any Market, available at Amazon and other fine booksellers in print and digital versions! 

Want to become a Winning Investor? Then be sure to get your copy today - The Winning Investor's Guide to Making Money in Any Market.