Are you a saver or spender?
If you went with the former, then you’re in the majority. According to a 2019 Charles Schwab survey, around 59% of Americans said they considered themselves savers. Compare that to more recent findings, however, and you’ll see that 63% of respondents in a similar demographic are currently living paycheck to paycheck.
Clearly, there’s a disconnect between the financial goals we are setting and the steps we are taking to realize them.
Many of us are taught from a young age that saving is the most direct path to building wealth and achieving financial freedom. But this is a myth. While saving is key in the pursuit of both goals, making smart investments with your money makes them much more attainable.
The fear that stops most people from investing is a reasonable one: financial loss as opposed to financial gain. When we work hard and are disciplined enough to forgo consumption and save, the idea of losing our hard-earned dollars understandably makes us uncomfortable. As a result, we tuck our money away in an FDIC-insured bank account.
Here’s the problem: The money we put into our accounts is almost guaranteed to lose value. The low interest rates that savings accounts offer can’t even keep pace with inflation, meaning our money’s purchasing power decreases the longer we save.
There is some good news, though. If you make smart decisions and invest in the right places, you can reduce the risk factor, increase the reward factor, and generate meaningful returns without feeling like you’d be better off in Vegas.
Here are a few questions to consider as you get started.
Why should you invest?
Saving versus investing is an oft-heard debate in financial circles. But they’re two sides of the same coin.
When building wealth, saving is an indispensable part of the financial toolbox — not because it produces wealth on its own, but because it provides the capital necessary to invest. At a minimum, investing allows you to keep pace with cost-of-living increases created by inflation. At a maximum, the major benefit of a long-term investment strategy is the possibility of compounding interest, or growth earned on growth.
How much should you save vs. invest?
Given that each investor enters the market because of unique circumstances, the best answer to how much you should save is “as much as possible.” As a guideline, saving 20% of your income is the right starting place. More is always better, but I believe that 20% allows you to accumulate a meaningful amount of capital throughout your career.
Initially, you’ll want to allocate these savings to building an emergency fund equal to roughly three to six months’ worth of ordinary expenses. Once you’ve socked away these emergency savings, invest additional funds that aren’t being put toward specific near-term expenses.
Invested wisely — and over a long period — this capital can multiply.
How do investments work?
Understanding the market: In the finance world, the market is a term used to describe the place where you can buy and sell shares of stocks, bonds, and other assets. To enter the market, don’t use your bank account.
You need to open an investment account, like a brokerage account, which you fund with cash that you can then use to buy stocks, bonds, and other investable assets. Big-name firms like Schwab or Fidelity will let you do this similarly to how you’d open a bank account.
Stocks vs. bonds: Publicly traded companies use the market to raise money for their operations, growth, or expansion by issuing stocks (small pieces of ownership of the company) or bonds (debt).
When a company issues bonds on the market, they are basically asking investors for loans to raise money for their organization. Investors buy the bonds, then the company pays them back, plus a percentage of interest, over time.
Stocks, on the other hand, are small pieces of equity in a company. When a company goes from private to public, its stock can be publicly bought and sold on the market — meaning it is no longer privately owned. A stock price is generally reflective of the value of the company, but the actual price is determined by what market participants are willing to pay or accept on any given day.
Other Types of Investments
You’re not limited to stocks and bonds, though. You can buy commodities, precious metals, investment real estate, or …
Stocks are considered riskier investments than bonds because of this price volatility. If bad news comes out about a company, people may want to pay less to buy shares than they did before, which will lower the stock price. If you bought the stock for a large sum of money, you risk losing that money if the stock price drops.
Stocks are also riskier because when companies go bankrupt, bondholders receive their money back — stockholders have no such guarantee.
Making (and losing) money: In the market, you make or lose money depending on the purchase and sale price of whatever you buy. If you buy a stock at $10 and sell it at $15, you make $5. If you buy at $15 and sell at $10, you lose $5. Gains and losses are only “realized” or counted when you make the sale of the asset — so the stock you bought at $10 could drop to $6, but you’ll only “lose” the $4 if you sell the stock at $6. Maybe you wait a year and then sell the stock when it’s up to $11, thereby gaining $1 per share.
Are you investing reasonably?
Now that you understand how investing works, it’s time to think about where you want to put your money. As a rule of thumb, remember that the best risk an investor can take is a calculated one.
But how can you be calculated? How can you distinguish a smart investment from a risky investment? Truthfully, “smart” and “risky” are relative to every investor. Your circumstances (e.g., age, amount of debt, family status) or risk tolerance can help you identify where you fall on the risk spectrum.
In general, younger investors with many years before retirement should have riskier portfolios. That longer time horizon gives investors more years to weather the ups and downs of the market — and during their working years, investors are ideally just adding to their investment accounts rather than taking money out.
Someone at or near retirement, however, is much more vulnerable to changes in the market. If you use an investment account to cover your living expenses, you could be forced to take that money out of the account during a downturn in the market, which would not only shrink your portfolio but also could ensure significant investment losses.
A higher-risk portfolio would likely encompass a significant number of stocks and fewer (if any) bonds. As young investors grow older and need to reduce the risk in their portfolios, they should reduce their investment in stocks and increase their investment in bonds.
The ebb and flow of life will influence your investments more than you may realize. Being realistic about your current financial prospects will keep you clearheaded about where to invest your money.
