These two phrases are similar, but very different. It seems people get them confused and it’s important to understand what differentiates them. If you read my last blog, I’ll assume you have already implemented some saving strategies. Good work. Now that we understand how to save, it’s time to take a deeper dive into what we do next.
Saved cash is important to have on hand, but a savings account is not going to make you rich. In fact, that money will decrease in value each year. Why? Inflation, which decreases your purchasing power due to rising costs of goods and services. Here’s a hypothetical example:
- Inflation increased at a rate of 3% for the year. Last year, a pair of shoes cost $100. This year, they cost $103.
- You put $100 in a savings account that earns 2% interest per year. At the end of the year, you’d have a total of $102.
See how that works? Your money is not keeping pace with inflation. It’s lost value and you can’t afford the shoes. Some people go their whole life without realizing this. Congrats, you aren’t one of them. I’m not telling you to empty your savings account, but rather look at it with a different approach. Generally, you should keep 3-4 months of expenses on hand (in checking or savings account). It’s the leftover cash we need to do something with – invest. Here’s our example continued for perspective.
- You put $100 in an investment account that earned a 7% return for the year. At the end of the year, you’d have a total of $107. Nike or Adidas shoes? Take your pick.
Investing is spending money now with the expectation of it earning a profit in the future. What can you invest in? Broadly speaking, there are four types of investment classes:
Stocks: Ownership of a company.
- Example: If you buy a share of Amazon, you are technically a part owner. If Amazon does well, your stock position will likely increase in value. For perspective, Jeff Bezos (Founder of Amazon) owns around 53 million shares of Amazon. He really wants the stock to do well.
Bonds: Like a loan, but you are loaning the money. Companies issue bonds to raise money.
- Example: Apple needs to raise funds for a new project, so they ask you to invest. In exchange, they agree to pay you back the full investment amount plus interest over a set time period.
Commodities: Raw materials.
- Example: Agricultural products (wheat), energy products (oil) and metals (silver). No, you do not own physical commodities. Good luck carrying a barrel of oil around.
Real Estate: Property or piece of land.
- Example: Buying a house and renting out to tenants. It’s likely the company you pay rent to is good at investing in real estate.
Some investments are risky, and some are safe. Risky investments may have a high potential, but also a low downside. Safe investments may not have as significant returns, but they can be consistent. How much risk should you take? Well, there are always two answers.
- Financial Answer: It depends on your age. Generally, younger individuals can take on more risk because they have more time. Older individuals may be a little more conservative.
- Emotional Answer: Everyone is different. Would you be able to sleep at night if the stock market crashed?
If the stock market does crash, do you permanently lose that money? No, if you stay invested, you can capture the upside once the market turns around. Remember COVID? Its news caused the stock market to drop 37% from February 12th to March 23rd in 2020. With that considered, the S&P 500 (largest 500 US companies) still gained 15.6% for the year. Do you see why time is on an investors side? The only people to lose money were those that sold at a loss.
Younger people may be able to take on more risk, but should you? If you are investing for a specific purpose (ex. buying a house) and will need the funds sooner than later, maybe your allocation is a little more conservative. Every circumstance is different, and you need to plan accordingly.
Investments are not easy. In fact, they are quite difficult. You’ll have some wins, and you’ll have some losses. Be patient and stay disciplined - it’s not about timing the market, it’s about your time in the market. Anyone can be a millionaire; you just have to know how to get there.
Gabe Martin is a registered representative of LPL Financial. Securities and investment advisor services offered through LPL Financial., a broker-dealer (member SIPC) and registered investment advisor. Insurance offered through LPL Financial affiliates and other find companies. CRN-3500474-031921
The S&P 500 Index is the Standard & Poor’s Composite Index of 500 stocks and a widely recognized, unmanaged index of common stock prices. You cannot invest directly in an index. Pat performance is no guarantee of future results. Asset allocation won’t guarantee a profit or ensure against a loss but may help reduce risk and volatility in your portfolio.