A Quick Guide to Saving And Investing For Your Financial Future: Retirement, College costs, Vacations, and More
Saving and investing — two sides of the same coin
Investing and saving are two of the most important components of personal finance. They are also two of the most confusing and intimidating concepts for most people. Investing, in particular, is a topic that is often shrouded in mystery, with lots of jargon and complicated terminology.
In this article, we will cover the basics of investing and saving. Although these terms are often used interchangeably, they are vastly different, and it’s quite critical that you are able to make the distinction when planning for your financial future.
What is saving?
Saving refers to the amount of money that is available over a certain period of time after you subtract out all expenses from your disposable income. Savings are most commonly maintained in cash or cash equivalents, such as bank deposits, which are exposed to minimal risk of loss but also yield minimal returns. Bank deposits tend to be very liquid and accessible in nature, and up to a certain amount, they are guaranteed by governments in most countries. For example, in the US, funds are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor.
Investing, refers to putting money to work, either directly in a project or an asset, such as real estate, or indirectly via buying stocks and bonds of established companies, aiming to generate positive returns over some time. Hence, returns can come from growing your own business, generating rental income, or collecting dividends from your stock holdings. Investing can seem like a complicated process that requires a lot of research and understanding. It’s not just about choosing the right stocks, bonds, or funds, but also about deciding how much to invest, when to invest and what type of investments to make.
So, which one is best for you?
The simple answer is that you need both. To what extent you need each will depend on several factors, including your total wealth, your periodic disposable income, the stage in your life cycle, and your needs and aspirations for the future. Hence, the higher your net worth and disposable income, the chances are that you will be able to both save and invest more, and vice-versa. However, as a proportion of your total wealth, you are likely to utilize a bigger part towards investing rather than savings, since most of your everyday liquidity and short-term needs will already be more than covered for.
Nonetheless, for most people, distinguishing between short-term and long-term goals can provide a better guide on whether they should be aiming mostly at savings or investing respectively. Consequently, defining financial goals for various aspects of your life can help you put things in perspective and be more focused on pursuing each one efficiently.
Splitting your money between savings and investing based on your financial goals
So, here are 4 examples of savings goals:
- Down payment for a house you are planning to buy in the next few years (usually 5 years or less), or to run home improvement projects. Having a plan to consistently put aside some money every month into a separate ‘bucket’ is the best way to have that much-needed down payment when the time comes to visit your bank for a housing loan. Banks tend to be very rigid with minimum down payment requirements, and therefore you need to be sure that you have enough funds readily available when you apply for that mortgage. That means that you cannot tolerate the risk of having your invested money in the financial market being worth less than the amount you need for the down payment. In the short term, investments in assets such as stocks can drop in value significantly. Being forced to liquidate your stock holdings during a recession to cover any short-term liquidity needs, such as a home down payment, can be devastating for your long-term retirement target.
- Car down payment. Although a down payment for a new car will not be as significant as that required for a house, it still makes sense to cover such a short term goal by saving enough money in a bank account.
- Vacation money. This could include saving a fixed amount every year for summer vacation or it could be saving bigger for a special vacation every two or three years. Again, it’s an easier goal compared to having enough liquidity for a house down payment but still, it is best addressed by planning ahead for adequate savings.
- Putting aside some cash for a rainy day. Life can be full of unpredictable events. It may be the case that you lose your job, or an unexpected illness within the family puts a strain on your finances. It is therefore imperative to have enough savings, usually at least 6 months’ worth of salaries, to cover such contingencies and thus avoid having your standard of living adversely affected.
And here are 5 examples of investing goals:
- Planning for Retirement. Taking steps for enjoying an adequate pension income during retirement years is perhaps the most important investment goal for the majority of people. Retirement planning starts at the beginning of your career, often spanning at least three decades. It is therefore a long-term goal and one which can be adequately achieved by being invested in the financial markets for the longer term. Assuming a typical market cycle ranges between 5 and 7 years, there is plenty of time to take advantage of booming economies and rising financial markets. This can help your investment portfolio to grow significantly over time and provide you with the necessary liquidity during the later years.
- Covering for kids’ college costs. Although not as a long-term goal as planning for retirement, assuming you start early on, you should be aiming for 10 to 20 years ahead. Again, this should provide enough time for falling and rising markets to take their course and hence add to the funding of your kid’s college. The closer you get to the time that you will need that money, and assuming you had a good run in the markets, it may make sense to shift some of your investments into cash savings, just to be more conservative.
- Down payment for a house, you are planning to buy in the next several years (usually over 10 years). Yes, there might be a thin line between planning for a down payment in 5 years as opposed to 10 years, but still, a 10-year horizon is not a short-term one, thus allowing you to take some risk with investing. Having said that, you may decide to go for a lower risk investment such as putting your money into government notes maturing just before you actually need the down payment.
- Starting your own business. Assuming this is a long-term goal, and that you do not intend to take a loan for this, it may make sense to invest in the financial markets to grow enough funds. At the same time, you may be doing a side hassle to help you generate the extra start-up cash for this goal.
- Leaving a financial legacy for your loved ones. Estate planning, like retirement planning, is one of those really long-term financial goals, best suited for investing for the long term. This may take several forms, including real estate, stocks and bonds. Your time horizon here is practically infinite, and as long as you pick the right investments, you shouldn’t be really worried about any gyrations in the markets or the economy.
Summary and key takeaways
Investing and saving is not the same thing. Investing is a long-term financial strategy while saving is a short-term financial strategy. Both are necessary to some extent to help you achieve your goals.
Investment decisions should be made with an eye on long-term goals and objectives, such as retirement or leaving a financial legacy for your family. Investing is about putting money into the financial markets in order to experience growth via cash flow payments and capital gains, and end up with more money in the future.
Savings decisions are best suited for meeting short-term needs such as down payments for a house or a car, or for unexpected expenses such as time spent in unemployment. Saving is entirely funding yourself, without relying on the economy or the markets.
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