Q. - If you had $25K to invest, how would you invest it?

A. - This question comes from a neighbor’s social media post, so I’ll start by considering why someone would ask such a question. Did they suddenly get an inheritance, bonus, or commission? Are they simply asking to see what others think is the best investment right now to move their money around? Or, are they thinking the $25k sitting in bank savings should be earning more than the minimal interest, so they’re looking for other options? But it really doesn’t matter what the motivation for the question is. What matters is how that $25K fits into the whole of one’s financial life.

For everyone who has ever raised the same question, before ever getting to the “investing” consideration, comes an evaluation of one’s financial foundation. Are bad debts paid off, and is acceptable debt managed month to month? Is an emergency fund built up to be ready when needed? Is spending controlled so that the budget has sufficient savings planned every month? Once the foundation is strong, investing can build on it.

And while investing is unfamiliar terrain for some, it really boils down to defining a goal, determining the risk one is willing to take to achieve it, and then selecting the appropriate investments to meet the goal. Basically, start with the question: why am I investing? Here’s an example. Your child is likely to go to college in 4 years, and you have decided to pay a portion of their education. Or you have decided it’s time to get serious about the down payment for your first house and plan to buy in 4 years. Both goals are in 4 years, but are not the same. The first goal is time fixed, while the second is time desired. In other words, your child doesn’t want to sit around waiting for a few years until the money is available, but the house purchase is more flexible, allowing you to wait another year or two, if needed. 

Investing, and the resulting compound growth, is crucial to achieving goals, a mechanism to grow money faster than inflation. And as you’re aware, inflation in recent years has made everything more expensive, from college education to homes to everyday expenses. So, keeping money in the bank is a guaranteed loss of value due to the low interest paid relative to annual inflation. While bank savings are safe from a large loss, inflation could wipe away at least 10% of the value of the $25K in just 4 years. So, investing aims to outpace inflation, compounding to grow even faster, and making it possible to achieve any financial goal.

However, investing has to consider risks: the risk of loss, the risk of underperformance, and the risk of even higher inflation. So, what risk of not meeting the goal is one willing to take in order to have a good chance of meeting the goal? In the example stated, you might want pretty good certainty of having at least the inflation-adjusted $25K at the start of Freshman year. On the other hand, you might be willing to strive for a little higher return for your house down payment because you could wait out a downturn in the investment value if that were to happen. But if the goal was retirement in 20 years, the answer would be totally different because of the time available to achieve it.

Now, let’s consider the time frame from the standpoint of investment selection. As the expected return on an investment increases, the risk increases and is reflected in the volatility of its value. Thus, those who choose riskier investments, such as a stock fund, can face days, months, or years with a loss in value, while over the long term (> 5 years), they are more likely to return more than inflation by several percentage points. But instead, a bond fund will be less volatile and carry a lower risk of loss, so returns will be lower over the long term. Is either fund guaranteed? No. Reasonable expectation of return greater than inflation, yes, for the stock fund. In fact, over 96 years, the S&P 500 stock index has returned less than inflation in 31 years. For the other 65 years, the average return was about 5 percentage points above inflation. Thus, the reason stocks are risky in the short term and certainly inappropriate for your child’s college bills in 4 years. Bond funds can keep pace, and even exceed inflation when interest rates are falling, but still have risk.

Finally, how certain are you that you won’t change your mind next month or next year? Or, if the investment value drops by 10%, will you sell it all to avoid a deeper loss? In other words, committing to an investment means committing to the long-term performance while accepting the volatility that will occur along the way. That’s why anyone who might need the entire $25K within the next 5 years shouldn’t have it invested in the stock market. If you might need some of it in an emergency, that amount should be set aside as emergency savings rather than in the stock market.

As you can see, what seems like a simple question has a complicated answer. Answering the question correctly requires thought, some investing education, and knowing your tolerance for risk. If you don’t do that work, your chosen investment might do well or might not, but more importantly, you won’t know why. You won’t even know the odds, so to speak. If you’re not at that point, it’s best to keep your money in a safe place like the bank (or Certificate of Deposit or Money Market Fund) until you can answer completely and confidently.

One last comment about the origins of the question. Because it was a social media post, the many responses were all over the map: Go to a financial advisor, Go buy Nvidia stock, just buy the S&P 500 index fund, my advisor recommends European Value, etc., etc. Many of the responses were advice without assessing the individuals’ circumstances. Of course, those who responded by recommending a financial advisor were partially correct in the sense that an advisor, acting as a fiduciary, would give unbiased, appropriate financial advice after assessing the client’s needs. Of course, the problem is the high cost of advisor fees, which would take a good percentage of the $25K. As such, they should be considered only for high-net-worth individuals, not small investors. Small investors can access much lower-cost “robo-advisors” provided by many financial services firms that make appropriate recommendations based on age, income, goals, etc.

You can learn more about investing in What Would Dad Do? - Volume 2: Investing and Climbing the Retirement Hill