Great Savings 38 – Put Savings First

 
There's money under the mattress.
Saving and investing are two concepts that are often used interchangeably, yet they are different and the differences turn out to be important when the goal is building long-term wealth. In today’s Great Savings Tip we attempt to distinguish between the two and discover why it’s so important to put savings first. 

 

Definitions

 

Let’s start with a couple basic definitions:

 

The concept of liquidity.

Can you get to your cash when you need it. If cash is readily available or we can quickly turn another asset into cash we call it “liquid”.

Saving: To save is to set cash aside in a safe place so that you’ll have easy access if you need it. The concept of easy access is often referred to as liquidity. A “liquid” asset is one easily converted to cash without a waiting period. Thus, a bank savings account is highly liquid as you can withdraw cash from it today, whereas a bank certificate of deposit (or CD) is slightly less liquid because you are penalized for an early withdrawal. To learn more about saving read our post: “How Much Should I Save Every Month.”

 

Investing: To invest is to set money aside by exchanging cash on hand for interest bearing cash accounts or other types of assets that may appreciate over time. Other assets can include such things as stocks, bonds, art, gold, real estate, collections and so on. As we are ultimately “hoping” the asset we own will increase in value we end up talking about the asset’s underlying risk. Generally, the riskier an asset is considered to be the greater the potential to appreciate, but also the greater potential for losing some or all of it. To lower the risk of investing be sure your investments are well-diversified. For more on this topic read: “Diversification: A Safe Money Machine.”

 

 

Differences Matter

 

Right off we can see two important differences when talking about savings or investment. These are (1) Liquidity and (2) Risk. Thus, anyone interested in building wealth will need to consider these factors as they decide what assets to hold for both short and long-term. Yet there are other considerations that also come into play. One of the most important is inflation.

 

The relationship between inflation and purchasing power.

In times of inflation our purchasing power goes down. That means are dollars don’t buy what they used to.

The concept of inflation boils down to this: When too much money chases too few goods prices go up. We might also say the value of our dollar goes down during times of inflation so our purchasing power is diminished. And this turns out to matter as we go to talk about savings and investment. If, for example, inflation is running at 4% annually and our bank only pays 1% interest on our savings account we actually lose 3% of our purchasing power each year. On the other hand, say we own a stock that appreciates 20% in value over the course of 5 years, and during the same time inflation runs an average of 3% per year. In this case we increase our purchasing power by 1% per year as a consequence. Here’s the math: ((20% / 5 years) = 4% per year appreciation – 3% inflation per year) = 1% inflation adjusted appreciation per year.

 

You might look at this example and conclude owning stocks is always better when it comes to inflation. Unfortunately, the higher risk of investing in stocks throws a big monkey wrench into the equation. If our same stock lost 20% of its value over 5 years, then we’d end up with a substantial reduction in our purchasing power. How much? Not only would we lose 20% of our original purchasing power from the stock loss, but we’d also end up losing another 15% for inflation—that’s 5 years at 3%. (Note: It would actually be more than 15% if we include the affects of compounding.).

 

Time is definitely a factor when it comes to investments.

With enough time an investment can recover from a substantial market loss. This is a critical reason why we should only invest with money we won’t need in the short-term.

Another consideration when it comes to investing is the length of time we hold on to an asset. In other words, if we can hold it long enough, any short-term loss we suffer can often be offset by a longer-term gain. Thus, along with liquidity, risk, and inflation, the amount of time we hold an asset is another critical factor to take into account.

 

Savings First

 

When it comes to savings and investing it’s not only important to understand the differences, but to understand which should come first. If you’re gambler and don’t mind assuming risk, you might abhor setting aside a portion of your money in a savings account, especially with interest rates at historic lows. Yet nearly all financial experts agree that before we invest any of our cash in riskier assets we create two types of saving. These include:

 

Emergency Savings: As a general rule of thumb experts advise putting a sum equaling 6 months of our annual income in savings to cover rent or mortgage payments, credit card payments, insurance, utilities, food, clothing and other expenses should we suddenly become unemployed or disabled. Creating an emergency fund like this should be everyone’s first savings priority.

 

Great Savings Tip 38 - Put Savings FirstSavings For Major Purchases: If we plan to get married, go to college, buy a car or home or expect another major purchase within the next 5 years, experts suggest saving for it rather than investing. Here’s why: If we invest money (say in the stock market) to cover a short-term expense and suffer a 50% loss the chances of the market turning around in that time to cover the loss are as much a matter of luck and/or market and economic conditions as anything. In fact, it could take much longer than 5 years to recover a substantial loss. Furthermore, we may not need a 50% loss to keep us from achieving our goal to begin with. For example, if a new car costs $20,000 and we lost 25% of our money due to a market crash in the stock market we’re $5,000 short in terms of buying the car.

 

Beyond savings, many experts also stress the importance of insuring what we already own before investing. This includes not only a home or an asset like a car, but our health. Clearly, the inability to pay for health expenses not only threatens our ability to accumulate wealth, but also our ability to stick around and enjoy it.

 

Exceptions To The Rule

 

Are there any exceptions to the savings rules above? There are two important cases consumers should never overlook:

 

Interest on credit cards is a burdensome tax.

Credit card debit is another piece to the puzzle. Generally, you’ll want to pay down debt first since the interest charges are so much greater than you get on savings.

Credit card debt: If we carry balances on our credit cards the chances are excellent we’re paying 18-25% or more per year. As no bank will ever pay interest on their savings anywhere close to this level and even a great investment can return substantially less per year, it pays big time to make getting out of debt a top priority. For more on the topic of the dangers of credit cards and how they encourage unnecessary spending read, “Danger Ahead: The Credit Card Disconnect.”

 

401K:  If offered a 401K by an employer and the employer matches some or all of our contributions it’s almost always better to invest up to the amount of the contribution. Otherwise we end up giving away free money. Investing in a 401K regularly and consistently can be a huge factor in building wealth for the long-term. For more on this important topic see our “Great Savings Tip 76: Invest In A 401K.”

 

There are many types of savings vehicles and investments. For more on these topics and the risks associated with them see our post: “What Kind Of Investing Is Best?”

 

Action Item: When was the last time your reviewed your finances? Do you know how much you spend over six months? Do you have an emergency savings account set up? Are you setting aside a portion of your income every month to invest? Take a look at the big picture and then set goals to maximize your wealth. If you need to beef up your savings figure out how to cut expenses elsewhere while you do it. For more ideas visit our Great Savings Tips page.

 

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