Saving and investing are both important components of a solid financial foundation. They also have unique properties that determine when each one makes the most sense.
The level of risk and reward is the most significant difference between the two. Savings often result in lower returns (through earned interest), but doing so carries little risk. Investments, on the other hand, can yield significantly higher returns, but also carry a greater risk of loss.
Since 1957, when the S&P 500 began tracking, stocks have averaged an average annual return of about 10%. By contrast, high-yield savings accounts typically yield less than 2%. While stocks are much more volatile in terms of price swings (as you may have noticed this year), this opportunity for higher returns makes them a valuable weapon in your financial arsenal. But it’s important to know when to use them.
Here are five questions to help you find the right risk and reward.
Question 1: Do you have any consumer debt?
If so, you are certainly not alone. But not all types of debt have the same impact on your finances. For example, a mortgage is helping you build assets. But high-interest credit card debt will keep holding you back. By paying it off first, you can save hundreds or even thousands of dollars in interest that you can then use toward other financial priorities.
Question 2: Do you have an adequate emergency fund?
Before deciding whether to save or invest, consider how much cash you’ll have to rely on in an emergency. What is “adequate” depends on several factors, such as your income and job security. The appropriate amount will depend on the individual and their level of risk tolerance. But these are some popular guidelines:
- While working, make sure to set aside 6-12 months for living expenses.
- When you retire, have 1-3 years of income equal to what you plan to get from your investments.
Question 3: How to save the best?
Because they’re not subject to market volatility (and are generally FDIC-insured), high-yield savings accounts are a great option for both your emergency fund and short-term savings. They’re also helpful when you’re trying to save for certain financial milestones. Saving in this way is a good option for many short-term needs—those with a 1-3 year time frame, such as buying a home or vehicle.
Choose simple online savings accounts like those offered by CapitalOne and American Express that allow you to earn some interest without risk. They also generally allow quick access to your cash, free and easy mobile access.
Question 4: Do you want more cash?
Besides savings accounts, another option to consider when you want more cash (or cash equivalents) is U.S. Treasury bonds. This will include Treasury bills, Treasury bills and Series I savings bonds.
As interest rates have risen in recent months, both Treasury bills (one-year or less time horizon) and Treasury bills (2-10 years) have yielded in the 3% range.
Series I savings bonds have become popular in 2022 due to higher inflation and higher yields (9.62% as of October 2022). However, there are some limitations, such as a one-year lock-in period, usually limited to $10,000 per person per year.
Question 5: When to invest?
If you’re looking to invest after 1-3 years — and you’ve paid off high-interest debt and have an emergency fund — consider investing in stocks, either individually or in funds. Even with occasional contractions, the market has historically risen in the long run.
To reduce risk, consider stocks with higher dividend yields. For greater risk (and hope for higher returns), consider “growth” stocks — those that tend to increase capital value rather than provide income. If you want to invest but are hesitant about the prospect of choosing and buying stocks, consider mutual funds or ETFs (Exchange Traded Funds). In these funds, you assume indirect ownership as a group of investors contribute to the purchase of the stock, and a professional fund manager makes investment decisions for you.
The important thing is to start.
There are no perfect rules and no guarantees when dealing with the market. Yes, investing can present some confusing options. But there are still some easy ways to get started. If you would like to learn more about how to ensure your funds work as hard and wisely as possible, please contact one of our professional advisors today.
Hunter Yarbrough, CPA, CFP, is CapWealth’s Executive Vice President and Financial Advisor. He is passionate about looking at personal finance from a holistic perspective, including investments, taxes, retirement, education, estate planning and insurance. For more information on Hunter and CapWealth, visit capwealthgroup.com.