While many people are interested in investing, having so many options to choose from can be overwhelming. So even though 90% of Americans say they want to build wealth, nearly half don’t know where to start and less than one-third have a non-retirement investment account, according to a Stash survey.
If you find yourself sitting on the sidelines — as you’re unsure which companies to invest in and how you should allocate to different types of investments — one approach could be to have a small bucket of money used to invest for fun and a much larger bucket for relatively safe investments (at least in terms of keeping pace with market returns, as all investments are subject to risk).
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In general, if this is an approach you want to take, then “the ideal percentage of fun vs. safe is 5% fun and 95% safe,” said Lauren M. Williams, CFP, co-founder of ProsperPlan Wealth.
Here is why your portfolio should be invested in 95% safe and 5% fun investments.
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What Does Fun vs. Safe Look Like?
Some people think investing is all about betting on the right company at the right time, but that can be incredibly hard to do well, even for professional investors. Instead of picking stocks of the specific companies that you’re betting will do well, one approach is to simply invest in diversified, low-cost funds.
“When building your wealth, it’s wise to consider a diverse range of investment options. For example, funds that track the broad stock market provide exposure to approximately 3,000 companies,” Williams said. “If one of these companies faces financial trouble or goes bankrupt, its impact on your overall portfolio will be minimal. If you have an overconcentrated portfolio that focuses on one specific company, if that company struggles financially or enters bankruptcy, you are officially out of luck.”
That said, some people aren’t satisfied with matching the returns of an index like the S&P 500. Although this index historically has provided a rough average of 10% annual returns, some people are eager to try to swing for the fences by picking stocks that they think will grow faster. Or maybe someone is just a big fan of particular companies and wants to buy their stock.
However, these types of investing approaches can carry significant risk, and it’s important not to put all your eggs in one basket.
That’s where the 5% fun and 95% safe strategy could come in handy.
Instead of not investing at all for fear of making the wrong choice, having a “fun” bucket in your portfolio could potentially help you get over the initial hurdle of putting your money to work, while the majority of your money could be in more diversified investments. And in doing so, you could become more engaged and comfortable with investing.
“Staying actively involved with the markets keeps you in the know. It’s tough to make smart guesses if you don’t understand what’s happening with a particular company,” Williams said. “When you’re invested in a single company, you’ll get plenty of updates about it and become more aware of overall market trends — both the ups and the downs. This often leads people to develop a real passion for investing. I’ve seen young advisors get so into it that they decide to become Chartered Financial Analysts.”
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Managing Risk
By limiting the fun bucket to a maximum of 5% of your portfolio, you can potentially reduce the risk that comes with overconcentration. If you have too much money in one company, or if you’re making wild bets on volatile stocks, you could be making life harder than necessary.
“In the 1990s, this client worked for a prominent tech company whose stock soared during the dot-com boom. As he approached his early retirement goal at age 40, he had accumulated around $6 million in his employer’s stock through options and the employee stock purchase program. Despite the stock’s impressive performance at its peak, the subsequent collapse of the dot-com bubble left him with a significantly smaller portfolio value,” Williams explained.
“Although the company didn’t go bankrupt, it never regained its former highs. Today, that stock makes up only a tiny fraction of his current investments, but his journey to retirement in his 60s involved years of rebuilding his wealth,” she added.
So by having at least 95% of your portfolio in more diversified investments, you can reduce this overconcentration risk and potentially enjoy the fact that the stock market historically has trended up over time.
Meanwhile, having 5% in fun investments can help you avoid issues like FOMO (fear of missing out) if your friends and family are investing in particular companies. That’s not to say that you should automatically follow the herd or that you should be willing to throw out 5% of your portfolio, but if maintaining these buckets helps you invest more in the first place while preventing you from getting too overconcentrated, then it might be a good approach.
Still, it’s important to understand that the fun bucket might not perform as well as the rest of your portfolio, and there’s a risk that you could get hooked by treating investing too much like a game.
“Fun investments are a really great way to develop good financial behaviors, but they have their downside too. More than once, I’ve seen ‘fun investing’ turn into something that looks more like a gambling addiction. Be really mindful of your trading and make sure you’re not getting in and out of positions for the dopamine rush,” Williams said.
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This article originally appeared on GOBankingRates.com: I’m a Financial Advisor: Why Your Portfolio Should Be 5% Fun and 95% Safe
