You will find plenty of advice about which stocks are hot and how to invest money in the market. However, many of these conversations leave out an important consideration: Why are you investing?
"When you look at investing, time horizon is one of the key things a planning professional will want to know," says Dan Yu, managing principal at EisnerAmper Wealth Advisors in New York City. Time horizon refers to when a person expects to need the money. Cash for next year's vacation needs to be treated differently than cash for a retirement 20 years down the road.
Elliot Omanson, managing partner at Sage Financial in Kansas City, says the biggest mistake people make is lumping all their money into a single account or fund. A better way starts with understanding how much money is needed for various goals. "Know the purpose of your account," he says.
Once that purpose has been identified, you should use different investment strategies depending on whether your money is being put away for the short term or the long term.
Saving for the Short Term
When it comes to money for short-term goals, finance experts say people should focus on saving rather than investing. Money needed in fewer than three years needs to be protected from market volatility.
"Short term is where people make mistakes," says Oliver Lee, owner of The Strategic Planning Group in Lake Orion, Michigan. "They see the bright light that says 6 percent and jump in." However, those types of returns usually require people to take risks they shouldn't with money that will be needed shortly.
For short-term goals, use the following options instead.
High-yield savings accounts. People should forget about investing money needed in the very short term. "It's hard to find an investment worth putting your money in for six months to a year," Omanson says. Instead, find a high yield savings account to keep money safe and instantly available. The best high-yield accounts only pay slightly more than 1 percent interest, but for this cash, stability is more important than gains.
[Read: 5 Ways to Heat Up Your Savings.]
CD ladders and money market accounts. You may be able to earn slightly more by placing money in a certificate of deposit rather than a savings account. However, the best rates are only available if you agree to tie up your money for at least a year or more. To keep cash liquid, some people set up CD ladders with varying maturity dates. This approach ensures at least part of the savings will be available at any given time.
Money market accounts can offer comparable interest to some CDs and come with fewer restrictions. However, you may be allowed only a limited number of withdrawals from the account each month.
Short-term bond funds. Once a person's time horizon moves past 18 months, it begins to make sense to place money in relatively stable investments. Short-term bond funds are one way to increase returns with relatively little risk.
Still, the gains on these funds are minimal compared to other investments. Ten-year annualized returns for even the best bond funds hover around 2 to 4 percent. "Accept the fact that the money is not going to grow a lot," says Steven Martin, director at BKD Wealth Advisors in Oakbrook Terrace, Illinois.
Fixed income funds. Similarly, fixed income funds offer a relatively stable way to get a return greater than that offered through savings or money market accounts. Many of these funds include bonds, but they may also include other securities.
"Investing entails risk," Martin says. "The shorter the time frame, the less risk you want to take." Fixed income funds don't offer much in the way of gains, but they are designed to minimize risk and limit losses in a down market.
Investing for the Long Term
For money that isn't needed for at least three years, look at putting at least a portion in stock market equities. "We can live though most bear markets," Yu says, noting most last from nine to 16 months. That means someone investing with a five-year time horizon can afford to risk a down market since their investments will likely rebound before the cash is needed. However, to be safe, people should begin moving money to bond and fixed income funds as it gets closer to when it will be used for its intended purpose.
When it comes to investing for the long-term, finance professionals recommend the following accounts.
401(k)s and IRAs. Money for retirement should go into one of these tax-favored accounts whenever possible. Employer-sponsored 401(k) plans may come with a company match for worker contributions. Plus, retirement accounts, including IRAs, offer either an immediate tax deduction or future tax-free withdrawals, depending on whether a traditional or Roth account is used.
Most plans offer a number of fund options, and target-date funds may be the best choice for those who don't want to bother with monitoring and reallocating investments as they age. Target-date funds are set up based upon when a person expects to retire. As it gets closer to that year, the fund automatically transitions money to bonds and other less volatile investment options.
529 Plans. For college savings, 529 plans offer tax-exempt withdrawals for qualified education expenses. Some states also let residents deduct contributions from their state income taxes. Like the retirement plans above, 529 plans often include target-date funds that can be selected based upon when a child will reach college age.
Index funds and ETFs. When it comes to money for other long-term goals, such as buying a house or starting a business, opening an investment account through a brokerage is the best way to put money aside. Within these accounts, index funds and exchange-traded funds offer low fees and the best value.
"I want a client to avoid paying 1 to 1.5 percent to a fund," Yu says. "That can really erode savings." ETFs and index funds are passively managed, which means they can keep their expenses low. Fees for these funds can be as little as 0.5 percent or less.
Index funds are intended to keep pace with the overall market, but ETFs can be more variable. Both contain a collection of securities that can help spread risk, but investors should do plenty of research before sinking money into a particular fund. "We get second opinions on everything, but we don't in financial situations," Lee says. He advises people to talk to several advisors when investing a large amount of money.
Actively managed funds are another option for long-term investments, although they can come with more fees and greater risk than index funds and some ETFs. Check with a financial planner to learn more about which funds are right for your goals and risk tolerance.
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