If you need to tap the cash in five years, stay away from volatile investments like stocks.
By The Mole, Money Magazine's undercover financial planner
NEW YORK (Money) -- Question: I'm 23 and make $50,000 a year. I put 8% into a 401(k) with a 4% match and $1,800 a year into a Roth IRA, but I would like to start saving to buy a house. I currently have $10,000 in an online savings account that earns 5% interest. Are stocks too risky for money I want to spend in the next couple years? Will bonds make more than 5% a year?
The Mole's Answer: Conventional wisdom says that a 23-year-old investor should be mostly in equities. As a general rule, I happen to agree but there is something much more important than your age - it's the fact that you want to spend the money in the next couple of years. I'm going to try to convince you that the stock market is far too risky for you or anyone needing to spend their investment in the next few years.
Now, clearly the stock market in the long-run is far more likely to outpace savings accounts, bond funds and other fixed income instruments. Let's say the stock market earns an average of 9% annually and your bond funds only get 5%. That means that in two years, the expected value of your $10K would be $11,881 in stocks vs. only $11,025 if you stick to your current online savings account. Thus, it's admittedly tempting to go with stocks and get that $856 in extra return.
The problem is that the savings account is relatively certain, while investing in stocks is very uncertain in the short-run, and two years easily qualifies as a short-run. Let's look at some history.
The chart on the right shows the worst performance of the stock market over the past couple hundred years, adjusted for inflation. The worst the stock market has ever done over a thirty-year period is to beat inflation by 2.6% annually. That's relatively little risk if you can keep costs low and stay in the market. And I'd recommend you put nearly all of your 401(k) savings in low cost, diversified equity funds.
If you need the money in two years, however, note how risky the market can be over such a short period. Over that period of time, the worst historical market drop was nearly 32% per year, which would translate to your $10K being worth less than half that amount in two years. Considering such a loss could result in you no longer being able to afford to buy that house, the extra return is probably not worth the risk.
Now there are planners who will tell you that they are bullish on energy stocks, emerging markets, precious metals and the like. I would steer clear of these sectors, as all you do here is place an even bigger bet on a small part of the market. These planners apparently don't know that they don't know what the next big winner is, and all they seem to consistently do is recommend a sector after it has already gone up. By then, it's probably too late.
As long as you think you are on track to save enough over two years, I don't think the extra risk is worth the extra boost in return. At least, don't take the extra risk if that goal of buying the house in two years is important to you.
For any funds you need in the next five years or so, stay in relatively conservative, fixed-income instruments. You can go with a high-paying money market - you would now do well to get 4% - or a short-term CD or high-quality short or intermediate bond fund paying 5%. Don't get greedy and chase an extra 1% yield by buying junk bond funds of companies that could default en masse with a major recession.
Keep doing what you're doing. Put your long-term 401(k) and Roth IRA money in low-cost equity funds, but keep any money you'll need in the next few years in safety.