Straight Edge Finance: The Most Important Question in Finance

“Straight Edge Finance” is a column written by Clark Troy, and presented by Red Reef Advisors

When do you need the money?

Everything flows from this question. But it can be so easily misconstrued.

If you need your money soon, you shouldn’t take any risk with it, which means you can’t expect too much by way of returns. So you have to use something like a money market fund or short-term Treasury bills, or a fund composed of them. If your investment horizon is longer, you can put your money in something which offers greater return potential at the cost of higher risk, because if your investment goes down in value it still has time to recover, and you can have a reasonable expectation that it will do so. This opens the door to investing in something with a higher risk/return profile, like a fund tracking an index of stocks or composed of a diversified selection of stocks (for today we’re going to leave aside questions about specific risks associated with owning individual stocks and bonds vs. diversified groups of them).

For the most part people seem familiar with the trade-off between timeframe and risk in the abstract. But the question of when a short period of time becomes a long one befuddles us in practice. All too often someone tells me something like: “I don’t need the money till the fall so you can invest it in something and make some money on it,” leaving me to dampen their excitement by telling them that it’s going straight into a money market fund.

In truth, there is no written-in-stone rule as to when the short term yields to the medium term, only in turn to become long term. But there’s general consensus that if you need money for a specific purpose — to pay tuition or fund a renovation, wedding, or car purchase – in the next 12-18 months, you should take essentially no risk. If you’re the nervous type, maybe extend that out to 24-30 months.

The spectrum of potential investments in essence presents investors with different variants of this trade off between time horizon – reflected in how long you must cede use of your money while it is “locked up” as risk ratchets up — vs. risk/return. The longer you can do without your money, the higher the theoretical return potential. The correlation between lock up and return potential is most transparent in the case of certificates of deposit, which offer higher but guaranteed rates of return the longer one cedes use of one’s money.

The table below draws attention to one further variable: that of cost. Investment opportunities and products present both hard costs expressed as fees – most often a percentage of the money invested in the products – and the soft costs associated with the option, from going to the ATM to get cash to researching thousands of publicly traded (and transparently documented with regulatorily-mandated reports) as well as a larger number of privately available options (private equity, private credit and hedge funds and direct investment in real estate and private businesses). Lower costs and higher transparency limit both return and risk. It’s the financial equivalent of the truism that when purchasing a service one can have cost, speed, or quality, but not all three.

Whew. There’s a lot to think about. And we haven’t even touched on the topic of account types, all these various 401ks, 403bs, IRAs, Roths, taxable brokerage accounts, 529s, donor-advised accounts and how one timing taxable income fits into this thought process. That’s a topic for another day.

Thankfully, some of these investment types — the so-called alternative assets comprising hedge funds and private equity and credit – are only available to investors adjudged by the government to be wealthy and knowledgeable enough to tolerate their higher risks. This is a good thing. The higher costs associated with these investment options are not there by accident. The universe of dangers in this less-regulated corner of finance is vast.

In any case, to return to our initial question. When do we need the money? All too often it’s hard to know. Certain expenses are fixed: housing costs, insurance, car payments, etc. Others rise and fall with the seasons and with our tastes and preferences. How long are we going to live? Will we get sick or injured? Are we done having kids or will we want more? Or get a bonus child? Should we front load vacations while the kids are young or wait till they’re old enough to really appreciate travel? Where will the kids go to college? Will the cost of eggs stay high? Should we remodel the bathroom?

There are lots of decisions, lots of uncertainties, lots to figure out. Eventually we arrive at answers, or the answers arrive.