So you have a great business idea you’re excited about and you’ve managed to squirrel away some seed money to make your dream a reality. However, you’re still not ready to launch your business. What should you do with your cash? Great question. This article will give you some clear and actionable advice on what you should do with your spare cash until your start-up takes off.
First of all, it is important to realize that a lot depends on your specific circumstances and goals. For this to work, you have to take a long and hard look at yourself and what you want out of this. Let’s get started.
The smart way to invest your future business’ capital will depend mainly on two factors: your time horizon and your risk tolerance.
What is your time horizon?
Your time horizon is the amount of time you want to hold on to your investment before you sell it and, hopefully, cash in on the profits. Time horizons can range from a few seconds, if you’re a day trader on the stock market, to decades, if you’re saving for retirement.
So, how soon are you expecting to start your business? Next year, in three years, in 10 years? The answer to this question will determine the pool of smart choices available to you.
What is your risk tolerance?
Risk tolerance is the amount of variability you are willing to stomach as an investor. Generally, high risk investments are more likely to generate larger returns but they are also more likely to generate larger losses. Your personal risk tolerance depends on your personality and how much money you can afford to lose. You can assess what type of investor personality you have by taking a risk tolerance questionnaire.
How much you can afford to lose will also depend on how much money you actually have now and how much money you need to start your business. If you know you are going to need a minimum of $45,000 to start your business and you only have $45,000 in savings, your risk tolerance is very low.
You probably shouldn’t get too aggressive with your investments, even if you are comfortable with taking risks. However, if your line of business has flexible start-up costs and you simply want to have as much cash as possible to work with, then you may consider taking some chances to maximize your returns.
The golden standard of growth investment is stocks. Investing 90% of your assets in stocks and 10% in bonds is usually the go-to advice for smart investing. At least that’s the advice Warren Buffet left his wife in his will. This isn’t however the case with short term investments.
Why? Let me answer with six numbers: +38.1, -38.50, +34.1, -29.7, +31.5 and -23.4.
Those are the three best and worst annual returns for the S&P 500 Index. This index includes the 500 largest publicly-traded U.S. companies and provides a good idea of how the market as a whole is performing. If you invested $10,000 in 1958, 1975 or 1995 (some of the best years for the stock market), and cashed in at the end of that year, you would have made $3,810, $3,150 or $3,410. Not bad for a single year. However, if you had made the same move in 1974, 2002, or 2008, you would have lost $2,970, $2,340 and $3,850 respectively. Now compare that with the average annualized S&P returns from 1980 to 2014, which was 8.5%.
For the long haul, a well-diversified stock portfolio is the way to go, but it can be risky in the short-term. Sure, you can invest some of your stash in stocks to increase your potential for growth, but don’t invest more than you can afford to lose, because the market can be extremely volatile.
Investment Options for Your Seed Money
Now that we have some data to work with, we are ready to talk about specific investments. To keep things simple, we have divided investment opportunities into two time horizon windows: 1 to 3 years and 5 to 10 years, and two risk tolerance levels: high and low. If you fall somewhere in between, adjust accordingly.
Short-Term Investments (1 to 3 years)
When you have a short time horizon, or less than three years, you generally can’t afford to be too aggressive. If your portfolio were to fall sharply, you could be forced into postponing your business plans. What you need are low-risk investments that you can sell at the drop of a hat.
Certificates of Deposit
Certificates of deposit are a safe and conservative place to park your cash. Granted, interest rates are low (usually around the rate of inflation), but it’s more than you’ll get in a savings account. The big advantage of certificates of deposit, as with saving accounts and money market accounts, is that your money is insured by the government. Even if your bank goes belly up, you will still get your money back. This is about as risk-free as any investment gets.
Treasury and Corporate Bonds
Treasury bills are bonds issued by the U.S. government, which are issued with three-month, six-month and one-year maturities. The bonds are auctioned out by the government at a discount price. When the maturity date arrives, the government pays out the full value of the bond. This makes them an investment that has high liquidity and is practically risk-free. It’s also one of the few money market vehicles individual investors can afford to purchase by themselves. You can purchase bonds for yourself from TreasuryDirect. Of course, this also makes T-bills a highly desirable investment in volatile markets, which means the government, always looking for a bargain, can afford to pay out dirt-cheap interest rates.
A similar alternative is to invest in corporate funds, which are slightly riskier because they are not insured by the government and therefore usually offer a higher return. However, they’re still a relatively safe option because they are often backed by the company’s assets if the business were to go under.
Mid-Term Investments (5 to 10 years)
If you’re expecting to park your money for five years or more, you can’t afford to just bury it in a low interest investment. In this time-frame, inflation – the increase in prices and your subsequent drop in purchasing power – starts to do some real damage. For example, according to the Bureau of Labor Statistics inflation calculator, if you had parked $10,000 in a savings account five years ago, you would have lost $1,086.76 to inflation, the equivalent of a 10% (2% a year) negative interest rate.
This means you may need to accept some risk to increase your potential return on investment. Your time horizon is still relatively short, so you can’t go crazy, but it’s long enough to include some growth investments, such as stocks and bonds.
Recent studies show the type of asset you invest in is much more important than the specific stocks or funds you pick. This is because diversification, not holding all your eggs in the same basket, is the key to consistent growth in unpredictable markets.
By hedging your bets you can ride the higher returns of investing in stocks and bonds and still protect yourself from most of the risk. The risk is still there, but it’s manageable.
To make this work, invest in index funds with low costs that provide broad diversification and automatically re-balance the assets in your portfolio. There are many investment companies that offer low-cost index funds, such as Vanguard, Fidelity and Schwab. My favorite are Vanguard’s LifeStrategy Funds, which are designed for mid-term investments of more than five years and offer four flavors to match your risk tolerance. Why are these my favorite? Vanguard has the edge in ultra-low fees and expenses: around 0.16%, compared to the industry average of 1.10%.
A similar option is to use an automated investment service, such as Wealthfront or SigFig. Although the fees are usually slightly higher, they can be more user-friendly for new investors who are not used to purchasing their own funds.
If you prefer doing your own investing, you can also create your own diversified portfolio by buying stocks and bonds directly through a brokerage firm. Keep your investment ratio at 60% of bonds and 40% of stocks to minimize risk. Another good strategy is to set fixed investment guidelines, such as selling any investment that increases in value by more than 20% or drops by 15%.
Note that you need a lot of money to create a truly diversified portfolio and you will need to invest a lot of time into research and trading. Because of the fact that the running expenses of wholesale investment companies are so low, building your own portfolio of stocks of bonds is nearly always a mistake.
Making the right investments for mid-term goals, anything between 5 to 10 years, is probably the trickiest time-frame to work with. If you need your money in a couple of years, your priorities are liquidity and low-risk, so your options are few: CDs, T-bills or a savings account.
In the mid-term time-frame though, getting the right balance of risk and liquidity is difficult. Bonds are considered lower risk than stocks and tend to do exactly the opposite of stocks. If stocks are tanking, bonds will probably rise and vice versa. Stocks are a little riskier, although this can be minimized by buying into a spread of high quality companies in different industries.
Hedge your bets by keeping most of your assets (60 to 70 percent) in bonds and the balance in stocks and you should be fine.
Disclaimer: This information is provided for educational and informational purposes only and is not meant as financial advice. It has been prepared without taking into account your specific objectives, needs and financial situation.