When putting money away, there are two ways to look at it. Are you saving for a vacation or new furniture? Are you saving for college or retirement? Depending on your answer, you will need to determine the most effective way to grow your money.
Everyone wants their money to grow, whether it be by interest or increase in value for a stock or mutual fund (investment vehicle made up of a pool of funds containing stocks, bonds and/or money market instruments). This is where timing comes into play. Time is important in considering what you do with your money based on your decision of saving vs. investing.
Let’s say you want to save for your children’s future. This could be college, wedding, or a down payment on a house. These goals, provided your children are still very young, are definitely long term. Therefore, putting away money in a savings account will not give you the best option for optimal growth over the long term. It is true that you will gain interest, usually monthly. However, the going rate for online savings account is approximately 1% annually. What does that equate to? Below is an example of putting $1000 in a savings account on January 1st and receiving an annual interest rate of 1% paid out on the last day of every month for one year.
A couple of things to notice here. First, when an interest rate is stated, it is intended to be the interest you will receive over one year. In this scenario, it is 1% annual interest rate. However, you will notice that $1000 multiplied by 1% should be $10. In the above scenario, the interest ends up being $10.05 over the one year period. This is because when interest is paid monthly, the annual interest of 1% is divided by the days of the year (365) then multiplied by the days in that month being paid. This is why February interest looks low. There are only 28 days of interest paid vs the other months of 30 and 31 days. Instead of a flat 1% over the year which is $10, you receive a benefit by being paid monthly. The reason is now in month two you are receiving a 1% annual interest payment on the balance of $1000.85 instead of just the initial deposit of $1000. You’re receiving interest on the interest you’ve already earned. This is called compounding interest. This is a great concept; but considering the stated interest rate is 1%, it’s going to take a very long time to grow $1000.
Now let’s look at another scenario should you decide to invest in a stock purchase. You would purchase a number of shares depending on price per share. If you want to invest $1000 and 1 share of stock is $50, then you would purchase 20 shares of stock. You do not earn any interest or returns on the invested amounts while the money is still invested. You only earn when you sell the investment. So after one year, should you want to sell and now the stock price is $55 per share, you would sell all 20 shares and receive $1100. 20 shares * $55/share = $1100. You increased your investment by 10%.
Why doesn’t everyone just invest in stocks? RISK
There is no risk in putting money into a savings account at a bank/online bank (FDIC insured). The bank guarantees you will never lose your initial deposited amount of $1000. When purchasing stock or mutual funds, there is no guarantee. So you could potentially lose all $1000 and be left with nothing. Of course, it’s not often that people lose their ENTIRE investment amount unless the stock investment is for a company that decides to close or file bankruptcy. However, it is often that people lose part of their investment. Should the value of the stock go down to $45 and you go to sell, you will only receive $900. You have now lost 10% of your investment.
Why does anyone invest in stocks if you can lose that much money? REWARD
Stock and mutual fund investments are meant to be invested in and held for longer than a year. Preferably many, many years. Most research will show greater, positive returns for stocks and mutual funds if held for at least 10 years. This doesn’t mean you can’t invest for 2-5 year time frame. It just means that with cyclical changes in the markets, you can expect to earn better returns if you can ride out the waves. Meaning, eventually you should see an upswing should the market go down and you don’t sell out of panic.
So how do you decide where to put your money? It really depends on time and what the goal is that you’re putting money aside for.
If you are saving for a new car, a down payment on a house, or saving up an emergency fund, you should put your money in a savings account at a bank. In these scenarios, you cannot afford to lose the value of what you’ve put aside. Also, in most cases these savings goals require you to commit to an amount. If your goal is to have $10,000 in 3 years in an emergency fund, you would put $278 away each month. By putting it away in a bank account, you know that at the end of 3 years you will have met your goal no matter what – with a few dollars to spare considering the 1% interest you have been receiving.
If you are saving for a vacation house that you have no intention of buying for 10 years or more, you would definitely consider investing in stocks or mutual funds. You have time to ride out the ups and downs of the market and, with careful research and planning, will most likely increase your investment by considerably more than 1%.
Investing outside of savings accounts requires patience and a somewhat of a strong stomach. Watching the value of your investment go up and down every day can take a toll. Once you have done your research and you are comfortable with investing into the stock market, you really should take a look every week or two only. You should consider reviewing every 3 months or so just to stay on top of it, but again, investing in stocks is a long term investment. You don’t want to purchase a stock and then turn around and sell it within a year. Your tax rate on short term capital gains can be significantly higher than if you were to hold and then sell after one year of investing. The more taxes you pay on your investment gain, the less return you are really receiving.
** These scenarios are at a very high level and do not include taxes or investment fees.