Editor’s note: This article was first published in July 2013. The annual returns of 1%-2.75% on fixed-term deposits, savings accounts and government bonds reflect Spain in 2013.
Suppose you have some savings you won’t need for a while, or you’ve come into some extra money from selling a property or winning the lottery.
Coming into an unexpected sum of money (say 50,000 euros) makes many people nervous, although most would ask themselves how they can multiply it. To answer that, we’ll use what personal finance calls the “risk bucket”, an investment strategy whose logic speaks for itself. So… how do we invest that extra money? What strategy can we follow?
Note: This strategy isn’t meant for someone who is building their own financial plan and is in the process of creating personal wealth. It’s aimed more at someone who receives a significant amount of money, has no idea about finance and has no plans to learn.
Two questions to ask yourself before investing your money
- How much risk am I willing to take?
- How long can I go without this money?
The risk bucket has three simple guidelines
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If you won’t need the money for 3 years, choose the no-risk bucket.
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If you won’t need the money for 5 years, diversify with more weight on risk.
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If you won’t need the money for 10 years, go for risk.
As most of you know, the no-risk bucket would hold fixed-term deposits, savings accounts and government bonds (with a maturity that matches how long we can go without the money).
See also: Assets that generate passive income (financial education, part 3)
On the risk side, we’re basically talking about stocks.
The 10 years isn’t a random figure. It’s based on the fact that, historically, there has yet to be a well-diversified stock portfolio that failed to generate a return over a 10-year cycle.
Pros and cons of using the risk bucket to invest
If we choose the no-risk bucket, the truth is we’d get annual returns of between 1% and 2.75%, which doesn’t go very far and probably won’t even beat inflation.
If we choose the risk bucket, we can earn big returns, especially if we’ve chosen our investments well, although anything could happen in 3 years. Ideally we’d hold on for those 10 years, or even until retirement.
As we know, more risk means more return, or bigger losses. We have to choose between “safety” and “high returns”. High returns don’t give us safety, and safety doesn’t give us good returns, so the two are incompatible.
I know we’re not handing out brilliant investment ideas with these simple guidelines. But for someone with no knowledge of finance who receives a large sum of money, I think that if they aren’t going to spend time learning about financial education and investing, the best thing is to use the risk bucket rule. I insist, though, that you need to be able to pick the right stocks if you opt for the risk bucket.
The rule is very simple: the longer you can afford not to touch that money, the more likely it is that the money will have grown by the time you need it.
Further reading
