In today’s post, we’ll explore the important distinction between saving and investing — two terms that, though often erroneously used interchangeably, must be treated in distinctly different ways on your path toward a thriving life.
Be Prepared for the Unexpected
Saving ought to be done first — and for a specific purpose. As we’ve discussed previously, one of the first milestones you need to hit as you pursue the thriving life is to save a full emergency fund of 3-6 months of expenses. The emergency fund is not an investment; rather, it exists to protect you from the unexpected expenses that will most certainly come your way.
Great places to keep an emergency fund include savings accounts and money market accounts (fnbodirect.com is a great place to get started). Though the interest you’ll typically earn on such accounts is quite low, they provide a few important benefits that you need for emergency savings. First, your principle is protected. This means that your value won’t go down in times of economic recession. This is important because oftentimes unexpected drains on your cash will come during times of economic hardship nationwide. With your savings in an account at a bank or in a money market account, you can rest assured that the $10k that you put in will be there when you need it.
Make Your Money Make Money
On the other hand, an investment ought to involve significant growth. While a savings account is earning less than one percent, a good investment should earn in the neighborhood of ten percent. But here’s the catch: that 10% rarely comes linearly. Unlike a savings account which will return 0.5% per year, every year, an investment may earn 5% one year, 30% the next, and -15% the year after that. The returns are a function of the market you’re invested in (e.g., the stock market or the housing market), so you never know how the investment will do in a given year. But, you can look at history to draw reasonable conclusions at what the investment should do long term.
Take for example a mutual fund we’re quite fond of here at totalthriver.com: Fidelity Contrafund. This fund is primarily comprised of stocks of large U.S. companies such as Google, McDonald’s, and Coca-Cola. The following chart shows the return for each of the last four years:
As you can see, 2010 was a great year for this investment, and 2009 was a lousy one. Of course if you knew that ahead of time you could make a killing! But since none of us have such knowledge of the future, we must simply follow the averages. This fund in particular has averaged 15% per year over the past 3 years, and 8% per year over the past 15 years.
Time Horizon is Important
Because even good investments like this one can fluctuate violently, most financial experts only recommend investing when you plan to leave the money alone for five years or more. Generally, this is a long enough period to ride out the turbulent ups and downs of the market, and give yourself a high probability of making money with your investment. For short-term savings (e.g. for a newer car or living room set), you’re usually better off to take the guaranteed 0.5% of your money market than risk losing 20% of your money should the market take a bad turn one year.
Make It Happen
In closing, it’s very important to recognize the difference between saving and investing. As you make progress toward your financial goals, you’ll need to be very intentional with which of the two you’re doing. Will you be using the money in the next two years? Open a money market. Will you be leaving the money alone for the next five years? An account with scottrade.com or a visit to your local financial advisor (see the “investing ELP” section at DaveRamsey.com) are great places to start. And as always, be sure to check back at TotalThriver for help along the way!