The Truth about Saving and Investing
Money doesn’t grow on trees, but money can blossom with the right financial strategy.
It’s important for individuals and families to start saving and investing their money as early as they can. After all, you work hard for your money, so let your money work hard for you.
Reaching Your Financial Goals
People save to reach their financial goals, like taking a trip or paying for a new car. Most individual invest to enjoy a steady stream of income when they stop working.
Because we can’t keep up with inflation, it’s important to put money away in an investment account that will grow substantially and increase in value.
Not only is hiding cash under your mattress unsafe, it also decreases your purchasing power over time. A dollar today is worth less than a dollar tomorrow.
Additionally, investing and saving fosters financial security for you and your family. Saving extra cash gives you freedom to use your money when and how you want.
It also cultivates discipline and encourages good habits. Sure, a daily latte or the latest fashion may be fun to purchase in the moment but delaying your gratification to be able to take a fabulous vacation or even create generational wealth is the ultimate legacy to leave behind.
Saving and investing requires sacrifice, but it is worth it every single time.
Frankly, investing is intimidating to a beginner. But we’re happy to bestow financial literacy to jump start your journey to saving money. Buckle up, this shouldn’t be too bumpy of a ride, but it is a lifelong adventure.
Basic Investing Concepts
Investing can be highly technical and is full of acronyms to get track of, but don’t let the jargon keep you from learning the basics. A fundamental understanding is all you need in order to get started.
There are so many resources online like this blog if you crave more knowledge, or you can partner with a trusted financial advisor to guide you through your journey.
Compound Interest
One reason it’s important to start saving and investing early, even if it’s small dollar amounts, is due to the power of compound interest. What is compound interest you ask? Any investor’s best friend!
Compound interest can easily be thought of as “interest on interest.” It is the interest on a deposit or loan calculated based on initial principal plus all accumulated interest.
Compound interest grows at an accelerating rate like this:
This formula shows the future value of an investment which is compound interest and the original principal amount.
Let’s look at an example. If you deposit $1,000 into a savings account that is compounded monthly at a rate of 2%, the value of your investment after 5 years will be…
P = $1,000
r = 2% or .02
n = 12 (# of months in a year)
t = 5
A = $1,000 (1+ .02/12)(12*5)
A = $1,105.08
So, your initial deposit will grow $105.08 just by sitting in an account. Think about how much your money could grow with a higher rate of return!
While we’re talking about basic concepts of saving and investing, let’s cover a few more terms to arm you with proper knowledge.
Rate of Return (ROR): The net gain or loss of an investment over a period of time expressed as a percentage. More simply put, it’s the basic growth rate and is sometimes called return on investment (ROI).
Annual Percentage Yield (APY): The amount of money in the form of interest earned on an account over one year. Represented as a percentage and includes compound interest. APY helps investors easily compare returns for different investments. Not to be confused with APR which is the annual rate charged for borrowing money.
Security: A negotiable financial instrument that holds monetary value, like stock, mutual funds, and bonds.
Dividend: A sum of money paid by public companies to its shareholders. A regularly paid portion of profits. Some investors choose to reinvest their quarterly dividends while others receive a check or direct deposit. Note: not all stocks pay dividends.
Dollar Cost Averaging (DCA): an investment strategy where individuals split the total amount to be invested into periodic purchases. This reduces the impact of volatility because each purchase occurs regardless of the asset’s price. Common practice among investors to mitigate poorly timed purchases.
Saving vs Investing
Whether or not you should “save” or “invest” depends deeply on your financial situation, and hopefully you’re able to do both because they are both important for you and your family’s future.
Pay yourself first by scheduling automatic deposits into your savings or investment accounts. Program it to regularly occur right after payday and you won’t have to think about it all year.
When the terms seem interchangeable, what’s the difference between saving and investing?
Risk and time frame are the key differences to note here. When you put your money into a savings account, it won’t make much extra money due to their traditionally low rate of return, but it will be safe. Savings accounts, money markets, and certificates of deposits issued by banks have backing by the FDIC, which is an independent agency of the U.S. government that protects your money from loss should your bank fail.
Conversely, when you invest money in an IRA or brokerage account, you have the opportunity to make more money, but also the risk to lose it all. Because of this, long-term financial goals like saving for retirement are best achieved through investing. Studies show that over a long period, money does grow overall in an investment account if you weather the ups and down bound to happen in the meantime. The historical average rate of return for the stock market for the last century is about 10 percent.
Basic Investment Rule
As a basic rule, the lower the investment risk the lower the potential return, and the higher the risk the higher the potential return.
Young investors are encouraged to be take a chance with their investments while more mature individuals nearing retirement should be much more conservative with their money.
Types of Savings Accounts
Emergency Saving Account: Financial experts agree that everyone should first set up an emergency savings fund before investing or paying down debt. If you’re stressed by a lot of debt, especially from high-interest credit cards, getting on top of that will be your next move before investing. The debt-snowball method is a popular way of getting out of debt, and any financial advisor can also help you devise a plan.
Can’t I just withdraw the money I invest for an emergency? Not so fast.
That seemingly harmless idea hinders the concept of compound interest, plus you cannot take distributions from certain investment accounts without paying a penalty in fees, taxes, or both. Withdrawing money from a retirement account should always be your last option in the event of a financial emergency.
Besides having an emergency fund at the ready, it makes more sense to save for short-term financial goals using a savings account instead of an investment account. Generally, if you plan to use reserve money within five years, do not put it in an investment account.
Saving for short-term goals like the down payment on a vehicle or a family vacation is one great way to use a basic savings or money market account. But there are also various savings accounts used for very specific purposes like healthcare or education costs.
Health Savings Account (HSA): A type of savings account that allows pre-tax contributions to help pay for qualified medical expenses such as deductibles, copayments, and coinsurance. Reserved only for individuals in a High Deductible Health Plan and has yearly contribution limits.
Coverdell Education Savings Account (ESA): A type of custodial account (meaning an adult opens it for a minor) with post-tax contributions, so growth and withdrawals are tax free for qualified expenses. Funds can be used for tuition and fees for K-12 and higher education, but accounts have a $2,000 annual contribution cap, and income limits apply.
529 Savings Plan: Another custodial account like the ESA since it is also funded with post-tax contributions. There is no annual contribution limit or income threshold. Qualified expenses include tuition, fees, and textbooks for K-12 and higher education, as well as homeschooling costs.
Despite being called “savings accounts,” the ESA and the 529 plan are technically investment accounts. You can set up either of these accounts for your child or other beneficiary with virtually any investment product you want—stocks, mutual funds, ETFs. With the rising costs of education, it’s helpful to save for it in vehicles with higher rates of return.
Types of Investment Accounts
Speaking of investment accounts, while saving for education is important, it’s not the first thing you should invest in. Instead, your initial investment should be in the retirement plan your employer or union provides for you, if you’re lucky enough to work someplace that does.
There are different types of accounts and plans but all are designed to help employees save for retirement.
The most common type is the defined contribution plan where you elect to have a certain percentage of your monthly salary deposited into a retirement account before taxes are removed and you receive your paycheck. Then, your employer matches the percentage you elected, up to a certain point. It’s imperative to fully take advantage of your employer match, otherwise it’s like you’re leaving free money on the table.
For example, the company you work for agrees to give their employees a 3% match. Your response should be to also contribute 3% at the bare minimum, but of course you can always contribute more.
Usually, these contributions are deposited into a 401(k) which the most popular type of defined contribution plan offered. In fact, over half of all Americans are eligible to invest in a 401(k) in any given year, but there are other types of employer-sponsored accounts.
403(b) Plan: A retirement account for public school employees and private tax-exempt organizations. Offers less choice in investment products than a 401(k). Participants include teachers, professors, and school administrators as well as doctors, nurses, and ministers.
457(b) Plan: A retirement account for state and local government employees.
Simple (Savings Incentive Match Plan for Employees) IRA: Used by small businesses with 100 or fewer employees. Employers contribute a 2% match of an employee’s salary or a dollar-to-dollar match up to 3% of the employee’s salary. Requires minimal set-up and has yearly contribution limits.
SEP (Simplified Employee Pension) IRA: A retirement account established by a small business or a self-employed individual that offers tax deductions on employer contributions. Annual limits are higher than those of IRAs and 401(k)s.
If your employer does not offer a retirement plan, or if you’re self-employed, there are other investment accounts you can open like the IRA and the Roth IRA.
These two types of individual retirement accounts have the same yearly contribution limits and distribution guidelines once you hit retirement, plus they both subject you to early withdrawal penalties.
Their main difference is their tax treatment.
You’re not limited to investing in only one type of account, just like how you can have multiple savings accounts.
You can have a 401(k) and your own IRA, however, yearly contribution limits still apply, regardless of how many accounts you open. Finally, you can have an IRA and a Roth IRA, but not multiples of them.
The last primary type of investment account available to you is a brokerage account. These hold the same type of investment products (think stocks, bonds, etc.) as retirement specific accounts, but they do not offer any preferential tax treatment. Typically, you must pay taxes on capital gains, or the increase in an asset’s value realized once it is sold.
Think of a brokerage account as a savings account with a beefier options, higher rate of return, and higher risk. If you’re aiming to save for something special in the not-so-near future, a brokerage account is an excellent choice.
Investment Products
Regardless of the type of account you open, and with an employer’s help or not, you have access to the same investment products. The combination of investment products, your “Asset Allocation,” can actually reduce risk and increase returns. Most people are familiar with the basics, but no judgement here if you need a refresher.
Stock: A security that represents the ownership of a portion of a corporation’s assets. Also known as “equity,” stocks are sold on exchanges and are the bedrock of many investor’s portfolios. Corporations issue stock to raise capital to operate their business, and units of stock are called “shares.”
Bond: A fixed-income security (meaning returns don’t fluctuate) that represents a loan between a borrower and lender. Like an IOU typically used by corporations or governments to finance projects. Bonds are considered a very safe investment.
Mutual Fund: A managed portfolio of stocks, bonds, or other securities devoted to an investment strategy. Offers investors built-in diversification. The saying is especially true in investing—don’t put all your eggs in one basket.
Exchange Traded Fund (ETF): A collection of hundreds or even thousands of securities like stocks and bonds. A single fund that tracks an underlying index, managed by a professional, and traded on stock exchanges.
Commodity: A raw material or agricultural product that can be traded. It’s a basic good used in commerce like gold, beef, oil, and grain.
Real Estate: Investors may purchase property to rent out or to “flip” and sell for a profit. Real estate investment trusts (REITs) are funds traded on major exchanges that offer investors real estate exposure without purchasing physical property.
You have more freedom over the specific types of investment products in your IRAs and brokerage accounts, whereas your employer probably only offers a limited range of products depending on its size. The larger the corporation, the more investment options it can present its employees.
Finally, there’s some fine print associated with all investments that reminds investors that past returns are not indicative of future profits and that certain types of investments carry more risk than others including loss of principal.
In Conclusion
When preparing to start saving and investing, ask yourself some probing questions to figure out what’s important to you. What age to I want to retire? How many children do we want? Will we be paying for their post-secondary education? Will my parents need long-term care when they age? Will we?
Common reasons people save and invest include education, retirement, long-term care, medical emergencies, and more. What do you value most and how long do you have to accumulate additional wealth to fulfill this objective?
The best time to start investing is yesterday; the second best time is today.
