The Most Important Rule of Investing
There's one golden investment rule that you should always keep in mind: never invest money that you can't afford to lose. Learn why this rule is important and how to protect your assets from risk and volatility.
Saving vs. Investing
There's a significant difference between saving and investing. Saving is setting money aside in a safe place where it stays until you want to access it, whether that's in a few days, a few months, or even several years. It might earn a little interest depending on where you put it, and it will be there for you in case of an emergency or to achieve the goal you're saving for.
Common savings vehicles include:
- Savings accounts: These accounts are Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) insured, which means each account is protected up to $250,000. They tend to have very low interest rates, especially at brick-and-mortar banks.
- Certificates of deposit (CDs): With these accounts, you leave your money in the CD for a period ranging from months to years. The interest rates are low but typically better than savings accounts. You can withdraw funds before the CD matures, but you lose some or all of the interest you've earned.
- Money market accounts: These accounts allow you to spend funds using checks or a debit card. They pay relatively low interest.
All of these accounts have virtually no risk, but you earn minimal interest.
Investing is the process of putting your money to work for you. It can typically make more money for you than the interest you might earn in a savings account or CD when done properly. But with reward comes risk. If you make poor choices or if things beyond your control go wrong, you could lose that money. It might not be there for you in case of an emergency.
Common investment vehicles include:
- Stocks: With these, you invest in a company and share in its profits and losses.
- Bonds: With a bond, you're lending money to a company or government entity. They typically pay a fixed interest rate. Government bonds are considered relatively low risk and may pay low interest rates depending on economic conditions. While bonds are relatively safe and could be used as a savings vehicle, they do have some risk depending on the type of bond.
- Mutual funds: These are investment vehicles managed by money managers. They may include stocks, bonds, and other assets. Buying shares in a mutual fund is a simple way to diversify your investments, and you can find mutual funds that reflect a wide range of interests and investment goals.
There are many more investment options, including collectibles, index funds, hedge funds, and annuities.
The Challenges of the Investment Rule
If you remember the "never invest money that you can't afford to lose" rule and never violate it, you shouldn't have to worry about running out of funds during retirement. You'll have the funds to handle something potentially catastrophic occurs like job loss or illness. The key is to build up your savings before you start to invest. You shouldn't invest money you need to meet other responsibilities.
There's a natural human tendency to want to overreach, put in more money than you can afford, and go for a huge payout. This trait tends to become magnified in the face of losses. This is referred to as the sunk cost fallacy—the belief that you've invested too much to walk away. Rather than selling in the face of losses, someone might hold on to a stock that's underperforming or, worse, buy more.
Guarding Against Investment Risk
You can't just look at your portfolio as the stocks you own. A portfolio encompasses so much more—your emergency cash reserves, your insurance coverage, your funded retirement accounts, your real estate holdings, and even your professional skills that determine the income you could earn if you lost your job and had to start over.
You can avoid the pitfalls of what's called "the refrigerator problem" by keeping your eyes on the big picture. The same folks who spend weeks studying Consumer Reports ratings for a new stove or refrigerator will sometimes put all their savings into a stock or other investment they don't entirely understand. Investments can be complicated, and a good financial plan includes factors like your retirement plans and goals, your other financial goals, and your risk tolerance. It's unlikely that investing in one vehicle will meet those goals.
When deciding how to invest in your portfolio, your first goal should always be to avoid major losses. You can do this through patience, keeping your management costs low, and seeking the advice of qualified, well-regarded advisors.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.