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How to Invest Safely (and Profitably)

A low-yield environment like today will produce lots of crazy ideas. Like this one from The Wall Street Journal…

In his article, “Putting Your Emergency Money in Blue Chips,” Brent Arends recommends buying blue chip stocks with the money you should have set aside for unexpected car repairs and living expenses in the event you lose your job.

Brent has obviously never had to deliver the news to someone’s grandmother that he lost 30% of her emergency fund when the market dropped unexpectedly. If he had, his idea would not look so rosy.

IDE’s Steve McDonald sent me this article this morning. Steve has been advising retirees on financial matters for 20 years. He’s seen plenty of accounts vanish due to unwise risk-taking. Here’s what he suggests…

Divide your liquid assets into three categories: emergency funds, investable funds, and speculative funds.

Your emergency fund should be held in cash or cash-like investments. This money should be available at a moment’s notice for emergencies that are outside your normal budget. Things like car problems, burst pipes, medical issues and the like. A good rule of thumb is to keep six to 12 months of living expenses set aside in this account.

It would be great to earn a nice rate of interest or collect dividends on these funds. But the primary purpose is to have this money available when you need it. All of it. To risk that money to the volatility of the stock market is crazy. Don’t do it!

In the second category of risk are your investable funds…

When your emergency fund is set aside, you can handle greater risk with the rest of your money. Even if you lost your job, your emergency money should cover your expenses.

Your investable assets are those you shouldn’t need to touch for at least three to five years. These funds will fluctuate in value. But with a longer time horizon, there is less likelihood you would ever have to sell at a loss just to meet your financial obligations.

Blue chips, dividend-paying stocks, high-quality corporate bonds, and certain exchange traded funds fit nicely into this category. If you manage a portfolio of these investments well and you add to it consistently over the long term, your wealth will steadily compound. This is the way to become wealthy by investing.

In the third category are your speculative funds…

The third category is optional. But the speculative category of your investment funds can add significantly to your return. And it can actually help to lower the overall risk of your portfolio.

You certainly don’t want to lose any of this money. But these must be funds that if you did take a significant loss, it would not affect your lifestyle or your retirement.

This category can include options, small cap stocks, large cap non-dividend paying stocks, leveraged ETFs, etc. You could also use these funds to short stocks and hedge against a falling market. The idea is that these investments should offer higher returns, but they can also be expected to fluctuate more and carry greater risk.

Where you fall on the continuum of risk is a function of your age and income level, your investing personality and market experience, and your ability to absorb or replace your losses.

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