How to balance between investment and savings accounts
A carefully considered investment plan can grow your wealth much faster than saving alone, but maintaining some of your money in savings limits your exposure to sudden downturns in the market.
Saving and investing can seem like two opposite approaches to growing your money over time, but their contrasting benefits make it important to do a little of both at once. A carefully considered investment plan can grow your wealth much faster than saving alone, but maintaining some of your money in savings limits your exposure to sudden downturns in the market and also provides a ready reserve for personal emergencies like job loss and unexpected medical bills.
Strike a Balance
Savings accounts are more stable and easier to access than most investment accounts. How much money should you invest, and how much should be held in savings? A good rule of thumb is to save what you must and invest what you can spare. Using your money to earn more money through investing is an attractive idea, but ultimately, money is only as useful as the things it can pay for. Good health, groceries, housing, utilities and transportation all represent unavoidable recurring expenses; multiplied over months of disability or unemployment and combined with occasional expenditures like entertainment, the bill for daily life can quickly become overwhelming.
Take some time to identify the expenses that your household encounters month after month. Then multiply those expenses by the number of months you feel an out-of-work scenario would last for you. Conventional wisdom suggests saving 3 to 6 months of expenses at minimum, but your actual downtime will vary depending on your skills, experience, and particular line of work, not to mention the state of the economy in general. If you are part of a multiple-income household, the burden of saving enough grows much lighter.
Consider Risk and Liquidity in Investing
Once you have a comfortable amount in savings stored away, you can begin to consider the many options you have as an investor. The greater the risk and longer the term of an investment, the more you will earn on the capital you provide. Government-issued bonds and bills, for instance, are safe bets, but they may not grow your money as much as riskier offerings like stocks can. Much like financial professionals do, you should seek to diversify your investments as a means of protection against fluctuations in the market.
Liquidity, which refers to a financial asset’s ability to be bought or sold quickly without changing its price, is another important factor to consider. When selecting investment products, you should consider how long you will be waiting for your money to become available. For example, shares in a mutual fund, which can be sold at will, are more liquid than a Treasury bond, which pays interest once a year and can take a decade to mature. One approach to alleviating the illiquidity of financial vehicles like bonds and CDs is to break up your investment into multiple smaller amounts, which then go into a number of individual investments that mature one after another, in staggered fashion. This “laddering” may be less efficient than investing the entire sum for a longer period, but it lets you retain access to a portion of your money for the short term. If you prefer a more hands-off approach to your investing, many people choose to turn their funds over to financial professionals or robo-advisors.
Minimize Fees and Maximize Interest in Savings
Just because your savings are locked away doesn't mean they can't earn you money. Finding a good interest-bearing option for your savings reduces the opportunity cost of holding back that money from more profitable investments. However, while all savings accounts earn at least some interest, the typical APY among standard savings accounts at major banks is only 0.01%. At this rate, it would take a deposit of $10,000 to earn $1 a year. Most traditional banks won't pay much more than this in yearly interest on savings balances, but they will charge account fees you must avoid if you don't want to see your earnings shrink even further.
One way to get higher APYs on savings accounts is to use an online bank. Liberated from the overhead costs of physical branch locations, online-only banks typically offer savings accounts with at least 1.0% APY. For the same reason, they also charge far fewer and lower fees than their brick-and-mortar counterparts.
This article first appeared in ValuePenguin.