The formula for financial success is: “Spend less than you earn and invest the rest.” But how do we invest the rest? What do we do with the money we have saved?

We have heard many times that, in investments, the higher the risk, the higher the potential reward. Let’s consider the risk and return of the most popular investment vehicles: savings accounts, bonds, and stocks.

Savings accounts.

The common belief is that savings accounts are the safest investment. When you deposit money in the bank, the bank and the government guarantee your money and your earnings. But this safety comes at a high price. Savings accounts, Certificates of Deposit (CDs), and Guaranteed Investment Certificates (GICs) pay little interest on your money.

In my opinion, depositing money into a savings account is a guaranteed way to lose money. The reason is that the interest offered is lower than the rate of inflation. Inflation is a cancer that eats away your savings and if your bank account is not keeping up with it, you are becoming poorer by the day.

I keep enough money in my bank account to cover my monthly expenses, anything extra is invested in the stock market.

Bonds.

Bonds are loans made to either governments or corporations. As with investment, the higher the risk the higher the potential return.

The safest bonds (lowest risk) are those which are sold by the government. In Canada and the US, the return on government bonds, most of the time, don’t cover the rate of inflation.

The next bonds on the scale of risk/return are provincial bonds and then corporate bonds.

Corporate bonds are rated according to the financial health of the corporation issuing the bond. They are rated from AAA to junk status.

Another factor to consider when purchasing bonds is the duration of the bond. The longer the term of the loan, the higher the risk. The risk of lending your money for 30 days is lower than the risk of lending your money for 30 years.

I don’t invest in bonds. Many experts recommend owning bonds because they are supposed to provide stability in a portfolio, but in my opinion, the stability provided by bonds is dead weight in a portfolio since their return is two or three times inferior to the return of stocks.

Stocks.

Stocks represent partial ownership of a company. When you buy one share of a company, you become part-owner of that company.

The biggest factor which determines the price of a stock is the earnings of the company. If the company increases earnings, the stock price will increase. Conversely, if the company decreases its earnings, the stock price will decrease.

Investing in stocks can be considered risky. Companies can go bankrupt from one year to the other or they can go up in value many times. Companies with stocks valued at $100 can go to zero in a few months, or companies with stocks valued at $1 can go to $100 in a few years. Apple was worth $2 in July 2004 and by July 2014 it was worth $128.

Since investors feel that having just one company in their portfolio is too risky, they spread the risk by having a basket of companies. That way, if one of them loses its value, hopefully, others will increase in value and their risk will be spread.

Mutual funds

A portfolio of 15 companies in different industries is considered a diversified portfolio. An easy way to have instant diversification is by purchasing mutual funds. For example, if you invest $1,000 in a mutual fund, your money is pooled together with the money of thousands of other investors and the mutual fund manager invests it in hundreds of different companies.

Giving your money to a professional mutual fund manager seems to be a fantastic idea, except for the fact that most mutual fund managers don’t have great performance records. In fact, a regular novice investor can do as well as any professional mutual fund manager. This is because mutual fund companies have many high expenses such as the high salaries of many research analysts, many overhead expenses, and the commissions paid to financial advisers.

Index funds

So how can you diversify without the high expenses of regular mutual fund companies? By investing in index funds.

Index funds are mutual funds run by computers. They are less expensive because they don’t have the high salaries of many analysts, they don’t have high overhead, and they don’t pay commissions to financial advisers. Unfortunately, since index funds don’t pay commission to advisers, advisers tend not to recommend them, to the detriment of their clients.

Conclusion.

In the long run (over 5 years), stocks have outperformed all other investments. Mutual funds offer instant diversification and index funds offer the best return for your money.

My strategy is to have some cash in my regular bank account to cover my monthly expenses and invest everything else. I don’t invest in bonds because my investment horizon is longer than 5 years. I invest in index funds because their expense ratio is lower than actively managed mutual.

Other personal finance blog posts

• What are your financial goals?
• Warren Buffett hates bonds and so should you
• Don’t waste your money on expensive wine