Weighing risk for young investors

(Money Magazine) -- Question: I'm 26 years old and keep my money, about $300,000, in a savings account because I can't handle the volatility of the stock market. Until the recession hit, I was earning at least 4%. But now I'm getting a pathetic 1%. What's the smartest way for me to get a decent return? -- Daniel, Brooklyn, New York

Answer: I'm sure I don't have to tell you that you're being extremely cautious for someone your age. Most advisers would recommend that you put at least 70% or so of whatever portion of your $300,000 you're investing for the long term in a diversified portfolio of stocks.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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Indeed, as a story in MONEY's July issue points out, some investment experts suggest that young investors plow even more than that into equities on the theory that they can afford to be gung ho on stocks because they have another big asset to offset stock-market risk: decades of future salary.

But what some adviser or expert tells you should be doing and what your gut says when the Dow takes a dive are two different things. So I sympathize with your desire to stick to the comfy confines of a savings account.

Problem is, as long as you relegate yourself to secure investments that protect principal -- i.e., cash equivalents like savings accounts, money market accounts, money-market funds, short-term CDs and the like -- you're going to be at the mercy of short-term interest rates, since rates at the short end of the maturity spectrum determine what these investments pay.

As you note, yields on such accounts have been pitifully low lately. And if last week's Federal Reserve Open Market Committee statement about the economy and monetary policy is any indication -- which I think it is -- short rates are going to continue scraping along the ground until the economy shows some pep, which could be a while.

But even when short-term rates start to climb, as they eventually will, it's not as if you're going to earn big bucks in your saving account. Historically, long-term returns in cash equivalents have lagged those of more volatile investments like stocks and bonds. Figures from the Ibbotson Yearbook, for example, show that from 1926 to the beginning of 2010, Treasury bills, which are a decent proxy for cash equivalents, gained an annualized 3.7% vs. 5.3% for intermediate-term government bonds and 9.8% for stocks.

There's no guarantee that stocks will continue to outperform or, even if they do, that the margin will be as wide in the future. As we've seen lately, stocks can go into an extended funk. But over the very long term, the odds of the most secure investments generating higher returns than more volatile ones are very, very slim. Which makes sense when you think about it. For it to be otherwise, people who take the least risk would have to get the most reward.

Financial markets don't work that way, nor does the world in general.

The practical implication of this is that you'll likely end up with a lot less money when you're in your 50s and 60s than you would have if you had you taken some prudent risks. Another way of looking at the cost of pursuing an ultra-cautious investing strategy, as I explained in a recent column, is that you'll probably have to save a lot more during your career in order to achieve goals like a secure retirement (although with three hundred thousand bucks in the kitty at age 26, you've certainly got a nice leg up).

Maybe you're okay with the implications of investing super conservatively. But you might want to at least consider some alternatives that may be able to boost your returns without causing too much agita.

Start by setting aside a portion of your 300 grand as an emergency or reserve fund. This is the money you'd need to pay unexpected expenses or to fall back on during periods of unemployment. Add to this any significant amount you think you might need over the next few years, such as a down payment for a house.

However much this comes to -- $25,000, $50,000, $100,000, whatever -- you should continue to keep in your savings account or similar vehicles, such as money-market accounts, money-market funds and short-term CDs. With a bit of shopping around you should be able to do better than 1% with this money, but, again, your return is pretty much dictated by the level of short-term interest rates.

You want to be particularly careful with this portion of your money to avoid investments that appear to offer a higher return with the same safety as a savings account or CD but that actually have latent risk, as was the case with bank-loan funds and auction-rate securities.

Whatever amount you have left -- i.e., the money you're investing for longer-term -- I suggest you consider creating a portfolio of stock and bond funds. You can get advice on how you might divvy up this part of your stash based on your tolerance for risk and investment time horizon by going to our Asset Allocator tool. For specific fund recommendations, you can check out our MONEY 70 list of recommended funds.

Since you're obviously extremely anxious about the value of your stash going down, you may want to scale back your stock stake from what our tool recommends. Even if you dial the recommended stock allocation way back, that's fine. You don't want to go beyond what you can emotionally tolerate and then end up bailing out of stocks at the bottom of a downturn. Besides, I think getting even a tiny bit of stock exposure is better than none at all. You can always re-evaluate your stocks-bonds mix later. To get an idea of what sort of risk you're looking at by incorporating different percentages of stocks into your holdings, try Morningstar's Asset Allocator.

If the idea of creating a diversified group of stock and bond funds with the long-term portion of your portfolio is just too much for you, then you might consider other secure investments that are likely to outperform a savings account over the long term. For example, another expert in that MONEY story I mentioned earlier recommends TIPS, or Treasury Inflation-Protected Securities, as they can protect the purchasing power of your money. You can buy TIPS through mutual funds or directly from the U.S. Treasury. And, of course, there are also good old savings bonds, which come in regular and inflation-protected versions.

Bottom line: I recommend you stop thinking of your three hundred thou as an indivisible sum that must be invested one way and instead, view it as two pots -- the first consisting of money you may need in the near term and that you want to keep absolutely safe, the second longer-term money with which you can afford to take some prudent risks.

But if you insist on taking a belt-and-suspenders investing approach with the whole shebang, you'll have to accept the lower returns consistent with that approach.