Imagine for a moment that you have received $10,000. It might be from an inheritance, it might be a bonus for outstanding work at your job, it could be winnings from a gambling trip (although, hopefully you’re not spending much of your money gambling); the source is immaterial to this particular example. Furthermore, imagine you have two possible options for this money: you can use it pay some of your student debt, which currently has a fixed interest rate of 7% annually, or you can put the money into a diversified portfolio that should return about 10% annually. Now for the question: which choice will leave you richer one year from now?
The correct answer, of course, is ‘I don’t know’. It’s pretty easy to calculate the financial repercussions of paying off the debt: Cutting down $10,000 of debt with a fixed interest rate of 7% will save you from paying $700 in interest, giving you a total net worth boost of $10,700. (Actually, you will save a little more; if the debt is compounded monthly, you would have paid $723 in interest on the debt by holding it the whole year, for a real total boost of $10,723 in your net worth.)
But the stock market investment is highly variable; while you can expect a 10% return over the long term (and even that is the subject of more discussion and argument than I’m going to get into right now), in any particular year, stocks could soar, they could crash, or they could be somewhere in between. Being able to predict how much stocks will return in any given year is a bit beyond the skills of most people; guessing a year in advance how the stock market or particular stocks will do is all but impossible.
Why do I bring all this up? Quite simply, there’s a tendency among financial writers (myself included) to skim over the difference between fixed returns and variable returns on your investments. Because variable returns are, well, variable, you should expect higher returns, on average, to compensate for the variability. If stocks yielded only as much as bonds while still being more variable in their return rates, they would have ceased being a popular investment choice a long time ago.
When considering your investments, then, you need to consider both the expected investment return and the variability of that return. When you can get a fixed return that is the same or higher than the highest reasonable return from a variable investment, you should go for the fixed return. If the choice is between paying off credit card debt at 23% or investing in the stock market and hoping for a 10% return, the obvious choice is to pay off the debt.
If the fixed return is lower than the expected variable rate, as it frequently is, things get more complicated. You have to consider how much of a premium will make the variable investments worth-while to you. If you are choosing between an 8% fixed and a 10% variable return, it might not be worthwhile, while the difference between a 6% fixed and 10% variable could be worthwhile to you. (Personally, I happen to follow the latter view, which is why I suggested paying down your debt to a level of six percent in my Ten Steps. Now, you have a better idea of the logic behind that suggestion.)
You also have to be aware of how much risk you are willing to take in order to achieve your desired return. It is possible to only invest in instruments with fixed rates and less rate risk, but you will have to deal with lower returns (and thus higher amounts that you need to invest). Generally, the suggestion goes that you should take more risk in variable return vehicles when you’re younger and have time to make up your losses. (Plus, if you have decades over which to invest, your returns should approach the averages, allowing you to treat the variable returns as close to fixed returns for your planning.) Then you gradually shift to investments with fixed returns as you get older, so the swings in value aren’t as severe.
Hopefully, all of this helps you to get a bit of a better understanding of some of the considerations you need to look at when comparing the return rates for your investments and debts.
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