Saving, by definition, means reducing your consumption. Investing is a different concept. Investing involves risk in order to grow your capital. And you need to do both!
When you deposit money into a savings account, you know that money will be there (plus a little interest) until you need to make a withdrawal. Part of the reason interest rates are so low on savings accounts, money markets and certificate of deposit accounts is because the money is safe. If you think you may need the funds within five years, you want to put that money in an account that you can withdraw from without penalty.
Consider what you might need money for in the next five years. Your first thought should be to establish an emergency fund. If your water heater breaks, if your car is damaged in an accident, if your child breaks a leg and has uninsured medical expenses or you lose your job-you need a liquid fund for these unforeseeable circumstances. Thinking about purchasing a home in the next five years? You should start putting money into a savings instrument now for the down payment. Want to remodel your home in the next few years? This should be money you put into a savings account, money market or CD.
Many people stop there and think they are doing pretty well because they see their savings account growing and feel comfortable. However, for long-term expenditures and retirement one wants to invest that money where it can grow. Your first investment goal should be to fund your retirement. If you have children, it is tempting to invest in a college fund but unless you have a sizable retirement portfolio that has to come second. Your children can take out loans and get scholarships to pay for college. Who will pay for your retirement?
So just how much do you need to save and how much should you be investing? Most experts agree that you want to have between three and six months of your living expenses saved for an emergency fund. The thought of trying to sock away that kind of money might be overwhelming but start with a smaller, manageable goal of putting away a month’s worth of expenses and building from there. Break that down even further to amounts per week you can have automatically deposited from your paycheck into a savings account until you reach that goal. Don’t get an ATM card for this account or if you do, lock it away somewhere so you aren’t tempted to spend this money for anything but an emergency! And if you are lucky enough not to need it, make sure to take a look from time to time at the amount you have saved and your current living expenses. Maybe five years ago you rented at $500 a month and now you are a homeowner with a $1000 a month mortgage. Your emergency fund needs to be adjusted for that change. Again, this money should be liquid so you can get to it quickly in an emergency and not pay a penalty when you do.
Once your emergency fund is established, you can begin to look at other goals for savings and investing. A major decision is how much to invest for retirement. Experts say you should be investing 10% of your gross annual income to be able to retire and live on 75-80% of what you earned pre-retirement. This is going to depend on how long you have until retirement, how you invest the money and what your standard of living is now and how that will change once you retire. You can use a retirement planning calculator such as this one from cnnmoney.com to help you get a sense of how much you will need for retirement. If you are employed full-time, chances are your company has a 401K or similar plan. If they have a matching program-do not pass up this free money! If you do nothing else, make sure you are contributing enough for the full company match.
Investing in stocks, IRAs, bonds etc. outside your company’s 401K plan can be intimidating. Now more than ever, there is real aversion to risk. However, over the long-term you need to be taking some risk to realize a return on your investment. Though you can buy stocks online these days with a click of your mouse, you really should spend some time reading and educating yourself first. Community colleges often offer courses on investing in the stock market for the novice at a fairly reasonable cost. If you don’t have a company 401K or are self-employed, you will want to look into an Individual Retirement Account or IRA. Knowing what type to invest in and how much you can contribute is key. If you are not comfortable with making these decisions alone, hire a professional.
Whether you are in your twenties and single or in your forties and married with children, it is not too late to take charge of your financial opportunities. Start by establishing an emergency fund and then any short term expenditures you need to save for. Establish a retirement plan before you try to pay for your children’s college and don’t forget to contribute to your company’s 401K plan!
Join us next week for the second installment in this three part series on Investing and Saving!