Young and too scared to invest in stocks

NEW YORK (CNNMoney) -- I'm 23 years old and working full-time. I'm on track to set aside about $10,000 this year. I'm typically very cautious, which makes me unlikely to invest in stocks or anything that is not guaranteed. So my question is: how should I invest my money? -- Laura Hochman, Lawrence, Kan.

Given the stock market's bipolar behavior recently -- soaring wildly one day, nose diving the next -- I understand why you prefer to keep your savings in something rock-solid.

That approach makes sense for money you might need over the next few years. If you're saving for a down payment on a house, a vacation or just to accumulate three-to-six months' worth of salary as a cushion against hard times, you want that money to be there when you need it. For those purposes, it should be sitting in something like an FDIC-insured savings account or short-term CD, even though you're hard-pressed to get even 1% a year from even the highest-yielding accounts.

But counterintuitive though it may seem, the fact is that hunkering down in the most secure options isn't a safe strategy when it comes to money you're putting away for longer-term goals.

Security has a price. And in the investment world, that price comes in the form of relatively low returns. Over the long run, there's no escaping this basic law of investing: The more secure the investment, the lower its potential gain.

So if you insist on sticking to investments with the lowest risk level, you're relegating yourself to subpar long-term returns. And doing that has its own risk -- namely, you may not be able to create an acceptable level of financial security or have a decent chance to retire without ratcheting down your standard of living.

Or, viewing that risk another way, even if you're able to achieve long-term goals while earning anemic returns, you'll have to save a lot more to do so. Which means you'll have to live more frugally today.

To illustrate what I'm talking about, let's take the case of a hypothetical retirement saver loosely based on you. We'll assume this person is 23, has $10,000 in savings, earns $40,000 a year and saves 15% of that salary. Initially, we'll also assume that, like you, our fictional saver is extremely cautious and invests 100% of her savings in low-risk short-term investments like money-market funds and short-term bond funds.

When I plugged this information into T. Rowe Price's Retirement Savings Calculator, it estimated that our hypothetical twenty-something has about a 62% chance of accumulating a nest egg large enough to provide a relatively comfortable retirement -- specifically, 75% of pre-retirement income from ages 65 to 92.

What to do with $10,000 now

That's not bad, but if that same 23-year-old invested her savings the way many advisers would recommend for someone just embarking on a career -- say, 70% in stock funds and 30% in bond funds -- the chance of attaining that same level of income in retirement climbs to about 90%. (In this case, I also assumed the portfolio would shift to a more conservative 50% stocks-50% bonds at age 65.

Of course, our 23-year-old could also boost her chances of a comfy retirement by saving more. But to achieve the same 90% probability without investing in stocks and bonds requires an annual savings rate of about 20% of salary. That might not seem like a huge difference from 15% at first glance. But consider this: going from 15% to 20% represents a sizeable 33% increase in one's savings rate, not to mention that 15% is already a very ambitious savings target. On average, 401(k) investors currently save only about half that amount.

In short, I think it would take quite a commitment to stick to such a savings regimen over the course of a career. And even if you could pull it off, doing so would give you significantly less spending cash during the years you're supposed to be enjoying life.

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I realize that putting 70% of your long-term savings in stocks and 30% in bonds might seem terrifying to you. But the point is that with many, many years of saving and investing in front of you, your main goal should be growing your stash long term, not worrying about protecting it from every market setback over the next 40 years.

If you invest the hyper-cautious way you prefer, your money may be safe in the short-term. But it's unlikely to grow anywhere near enough to provide you with financial security over the long run.

So by all means stick to the most secure options like FDIC-insured savings accounts for your emergency stash and the money you'll need within the next few years. For the money you're putting away for longer-term goals, however, I suggest you consider taking the prudent risk of investing in a portfolio that includes both stock and bond funds. (If you're uncomfortable putting together such a portfolio yourself, consider investing in a target-date fund, which gives you a diversified blend of stocks and bonds all in one fund.)

Or you can continue to invest all your money with only immediate protection in mind. In which case, I recommend you begin honing your savings skills even more.

This story was corrected on November 4, 2011 at 5:30 p.m. in order to correct the calculations in the hypothetical example.