Risk and reward. One implies danger and the other success, right? Not exactly. With investments, it’s difficult—or even impossible—to have one without the other.
That’s why experts recommend a diversified mix of investments: a portfolio that’s balanced and broad enough to cover a variety of market conditions and seeks to avoid volatile swings in value.
Balanced Portfolio: Each Investment Plays a Role
Let’s look at an example of what a balanced portfolio might look like over time—just starting out through retirement. One thing you’ll notice is that the investments aren’t static. The percentage of each type—stocks, bonds and short-term investments (short-term bonds, money markets, cash equivalents, etc.)—gradually changes over time.
That gradual shift is important. Younger investors have more time before retirement to make up for any losses from market declines and can tolerate the risk inherent to stocks. Those nearing or already retired may need more conservative choices to protect against sudden drops. But they still need some growth (via stock exposure) to carry them through a full life in retirement.
Are You Unbalanced? Portfolio Makeup Over Time
Hypothetical Change in Stock, Bond and Short-Term (Money Market) Holdings
Source: American Century Investments.
The Risk of Missing Ingredients
Many investors are tempted to sell their stocks and even bonds during volatile markets. But what does that do to your overall portfolio mix? Too much in money markets, for example, means you may miss out on future stock and bond market gains.
If you’re tempted to cash out or shift to less volatile investments, consider the risks you face with that decision.
Money Markets: You May Not Need As Much As You Think
Generally, you may invest in stocks for growth and bonds for income. Money markets, on the other hand, are used for their relative safety: They help preserve capital, provide liquidity if you need the money quickly, and along with bonds, they can provide a hedge against major stock market swings.
Reasons to hold money markets:
Buffer against volatility. The stock market can fluctuate significantly and may result in a wide range of returns. Money market values are more stable because they are designed to keep a set price of $1 per share.
Emergency fund. Experts generally recommend that you save three to six months’ worth of living expenses. Money markets’ ability to preserve your capital can help ensure the value of your emergency fund doesn’t vary much.
Short-term goals. You may want to hold money markets while you’re working through a large one-time purchase, such as a down payment for a house.
Too Much of a “Safe” Thing Is Also an Investment Risk
But many investors don’t always consider that “playing it safe” isn’t always safer.
Cashing out stocks or bonds in favor of money markets not only locks in losses, it may cause you to miss out on growth when the market eventually recovers. Rebounds are nearly impossible to predict and can pass you by while you wait on the sidelines.
Consider the historical chart below, which uses common indexes as an example. Selling stocks during the 2008 financial crisis may have avoided a further drop in value, hypothetically speaking. But starting in 2009, stocks made up those losses—and then some. Bonds, too, continued climbing after the downturn.
Source: American Century Investments, FactSet. Hypothetical value of $10,000 invested at the beginning of 1980 to March 31, 2021. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Past performance is no guarantee of future results.
U.S. stocks are represented by the S&P 500® Index. U.S. bonds are represented by the Barclays Capital U.S. Aggregate Bond Index. T-Bills are represented by the FTSE 3-Month U.S. T Bill Index, which is often used as a benchmark for money market investments.
More recently, equity markets plunged at the beginning of the COVID-19 pandemic in early 2020. However, stock prices quickly recovered, and the S&P 500 rose 18% over the entire year.¹ Investors who panicked and sold stocks early in the year may have locked in losses and missed out on future gains.
Money Markets vs. Inflation: Don’t Fall Behind
Inflation is another major risk when seeking safety. Money markets have only averaged an annual return of 0.13% since 2000.² The rate of return on these investments generally hasn't kept pace with the rate of inflation, which averaged about 2.13% annually over the same period.³ So what happens to your portfolio if your money markets can’t keep up? You could get negative “real” returns (i.e., the returns after subtracting the inflation rate).
Historically, Money Markets Have Had Negative “Real” Returns
Returns After Accounting for Inflation
Data from 1/31/2000 to 3/31/2021. Source: FactSet, Bloomberg, American Century Investments. The inflation rate is annual calculated every month. Past performance is no guarantee of future results.
Assuming inflation averages about that much for the next 20 years, $1 today will only be worth $0.64 in the future.⁴ In the pursuit of protecting your money from losses, you may also lose purchasing power over time.
Risks of holding too much in money markets:
Opportunity cost. Money markets don’t provide much opportunity for growth or income. They have historically provided a lower rate of return over time compared to most stocks and bonds.
Lack of diversification. A diversified mix of bonds can also be used to hedge against stock volatility while having higher return potential than money markets.
Inflation risk. Inflation may outpace money market returns, undermining your future purchasing power.
The Fear of Running Out of Time
Many investors may be concerned that they don’t have enough time to make up losses due to volatile markets, particularly if they’re nearing retirement. Cashing out may seem like the best option to preserve a nest egg. Others may take on additional stock risk in an attempt to gain back any losses.
But investors have more options than just being all in or all out of the markets; it doesn’t have to be an either/or decision. There are a variety of options across the investment risk spectrum to choose from.
Evaluate Your Options: Bonds May Help
What if you’re seeking more growth opportunities than money markets while looking for more potential stability than equities? Bonds are a key component in any diversified portfolio and may provide a middle ground when timing is crucial. Core bond holdings provide more income opportunities than money markets and can also help temper the more volatile swings associated with stocks. Read more about the potential risks and rewards of bonds in a portfolio.
During periods of volatility, bonds have the potential to provide steady income through yields. They also provide diversification that helps balance risk and return. Often, bonds that are maturing in a shorter period of time may experience less price volatility.
A Path Forward
Remember, the percentage of each type of investment in your own portfolio should always depend on your personal situation, comfort with risk and time frame.
If you’re worried about the market impact on your portfolio, we can help. A comprehensive financial plan can help ease your fears and chart a course forward.
Source: FactSet. Data as of 12/31/2020.
Money market returns are represented by the FTSE 3-Month U.S. T Bill Index from January 2000 to March 2021.
Inflation returns are represented by the Consumer Price Index. Data from January 2000 to March 2021.
Source: American Century Investments, Financial Calculators from Dinkytown.net. Financial Calculators ©1998-2020 KJE Computer Solutions, LLC. Inflation data from 2001 to 2020.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.