The stock market dropped every year from 2000 through 2002. And today, with increased global tensions, a struggling economy and mixed reports on corporate earnings, the market outlook remains uncertain.
Consequently, you may have taken a time out from investing and "parked'' substantial amounts of your assets in certificates of deposit, money market accounts or other investments in which your principal is generally protected. But how long should you keep this "parking spot''?
You may feel that putting your money in these kinds of vehicles is a safe way to "ride out'' the turbulent markets. And, in the current political and economic environment, the stability of principal offered by CDs and money markets is indeed a factor to consider. And yet, you'll need to be careful not to keep too large a percentage of your funds in these types of investments for too long.
Why? Because you could run into problems you may not have considered.
To begin with, keep in mind that the longer you park your money, the less safe it is from the threat of inflation. In today's low-interest-rate environment, many fixed-income vehicles offer returns that barely exceed the inflation rate -- if they exceed it at all.
Your first thought might be that inflation isn't much of a threat today. And it's true that over the past several years, inflation has been quite mild, especially in contrast to the period of the late 1970s and early 1980s. However, although inflation has been low, it hasn't disappeared entirely, and, over time, even a low rate of inflation can add up, eroding your purchasing power. For example, in just 20 years, an annual inflation rate of four percent would drive the value of a dollar down to $0.44.
Clearly, you can't afford to tie up too many of your investment dollars in vehicles that won't keep you ahead of inflation.
But there's also another danger of "parking'' your money for too long.
There is an "opportunity cost" you pay for staying on the investment sidelines. Every "bear'' market in history has ended, sooner or later, and the biggest gains in stock prices have usually been recorded in the first few months of a recovery. (However, you must remember that what happened in the past doesn't necessarily indicate future results.) If you are still parked in money market accounts and CDs when the stock market turns around, you might miss out on growth opportunities.
So, given the dual needs of staying ahead of inflation and staying invested in preparation for a recovery, when should you think about pulling out of the parking lot? After all, neither you nor anyone else can predict the future course of the financial markets.
Here's the answer. Don't park -- diversify.
By keeping your investment dollars in a wide range of high-quality stocks, bonds, money market accounts, CDs and government securities, you can reduce the effects of market volatility and give yourself more chances to succeed.