Consistently saving money is a fundamental part of becoming financially independent. But where should you put this money – a savings account or investments?
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”
– Robert G. Allen
First thing’s first – saving money is always a good idea.
Most people are taught that saving is a necessity from quite a young age – usually by their parents. Others might have to learn the hard way, and quickly understand the benefits of not blowing all their money once they start earning it themselves.
As everyone who’s done it knows, rummaging down the back of the couch for spare change at the end of the month is no fun.
Regularly putting aside money just makes sense. It protects you against those unexpected and often expensive emergencies, helps you to build towards larger purchases like a car or a house, and on a more philosophical level, lets you appreciate the rewards of hard work.
Savings aren’t just a way of future-proofing yourself though. Much like ourselves, money changes over time, and the cash that you have in your pocket right now could actually be worth a lot less in a year’s time if you do nothing with it.
This is due to inflation – the decrease in the value of money over time as wages remain stable and the cost of living goes up.
To put this into perspective, think of how the price of everyday items increases over time. The average cost of a gallon of milk in the US is currently about $3.50. This is likely to increase over the next few years due to inflation however, which means that the same gallon of milk might cost $3.75 or $4 in a couple of years.
So if you’ve kept that $3.50 aside in cash to buy your future self some milk (hypothetically of course), it won’t be enough anymore. The physical makeup of the money obviously won’t have changed, but its purchasing power in a future market will have decreased.
But if that $3.50 was put into some sort of savings scheme, it would earn interest over time that will counteract the effect of inflation to some degree. So far from just protecting yourself from future costs, saving money actually limits the effects of devaluation on your cash too.
So we can all agree on the assorted benefits of saving money. But how should you save money?
The classic trick of hiding money under your mattress won’t work anymore. But is a traditional savings account the only sure-fire way to put money away for a rainy day? The very fact that it’s called a ‘savings’ account is reason enough for most people.
However, although a savings account is useful in terms of short-term financial security, you’ll find it impossible to build any significant long-term wealth from one.
Savings vs Investing: The Facts
Anyone with a bank account (which includes everyone reading this I hope) will have a regular checking account that they use day-to-day.
A savings account operates a little differently to a checking account, as it won’t allow you to carry out regular transactions through it like paying a bill or withdrawing cash from an ATM.
A savings account will earn you money through interest however, protecting the money deposited in it against some of the effects of inflation as we’ve already mentioned. Savings accounts are subject to an annual percentage yield (APY), which is the rate of interest that accumulates on the money you have saved over time.
This is typically around 1% a year in the US – but is subject to the wonderful workings of the compounding machine which means that your savings will grow at an increasing pace over time.
But is it the most efficient way to put your savings to work?
People on the fringes of the investing world tend to think that investing is just an elaborate form of gambling – a 50/50 shot of making it big or losing it all.
But as we’ve mentioned before, the stock market only acts like a casino if you treat it that way. If you approach the stock market with a level-headed and long-term strategy, it’s actually one of the best ways to build significant wealth.
Take the S&P 500, which has had an impressive average return of about 10% per year. Not only is that a far-sight better than the yearly return of 1% you’d get with a savings account, but it’s also been proven that if you had invested for a period of 20 years at any time over the S&P 500’s history (including the Great Depression, the Dot-Com Bubble, and the 2008 Banking Crisis), the statistical chance of you losing money is – zero.
That’s not gambling, that’s just plain sense.
So How Should I Save?
Investing as a method of saving money only really works if you’re thinking long-term. If you invest money only to take it out again in a few months time, any gains you have made will be eaten up in taxes and charges.
So the best thing to do is a take a diversified approach.
Protect yourself against unexpected costs in the short-term by building up at least two months wages in a savings account. Money in a savings account can be withdrawn at relatively short notice, so while your money is safe in an account earning marginal interest, you can also access it at any time.
Once you have that financial safeguard in place, then you can start investing money in stocks for your future. Remember, any money you invest in the market should be left there for a minimum of five years, so make sure it’s not money you’ll need any time soon.
If you want to play it safe and follow the fortunes of the market, you can invest in an ETF – a curated list of stocks that gives you exposure to a wide range of companies. Some ETFs, like the Vanguard S&P 500 index, track the S&P 500 index closely – allowing investors to enjoy the 10% average return over time.
Once you’ve invested in that solid foundation, you can then start investing in some individual companies that you believe will do well in the future.
This doesn’t require you to take big risks in small companies a la the Wolf of Wall Street. In fact, one of the most important prerequisites to become a great stock picker is an awareness of the companies and businesses you interact with on a daily basis.
Do most of your colleagues use an Apple smartphone, or do they prefer Google’s Android system? Do they go to a Planet Fitness gym at lunch decked out in their Lululemon gear, or do they hit up a Buffalo Wild Wings instead? Do they drive home in their trusty Ford or a brand new Tesla?
These are all public companies that we interact with every day and are the key to success in the market. If you’re already buying their products (think of how many Coca-Cola products you’ve consumed in the past year), you may as well profit from their success too.
Plus, if you buy shares in a company that you truly believe in, it’s a lot easier to leave your investments for the long run and watch them grow.
Saving is a necessity of financial independence. However, it doesn’t have to be a case of stashing some safety funds away in a dusty old bank account that earns meager rates of interest every year.
Get your finances in check, build a small emergency fund, and then start investing in some of your favorite companies and watch your savings grow with their successes.