So you’d like to really crush your financial goals, and you’re ready to start socking away some money.
You may have heard experts say you should have some money in savings accounts, and some money in investment accounts. But how do you know the right way to divide up your funds? Understanding when to save and when to invest will set you up for long-term success.
“Saving is the foundation that makes it easier to stay committed to investing for the longer term,” says Bryan Bibbo, a financial advisor in Avon, Ohio.
Timing is a big part of whether it makes more sense to invest or to save. The sooner you might need the money, the less risk you can afford to take. That’s when you save. The longer your goal—hello, retirement!—the more risk you should consider taking for higher returns. That’s when you invest.
A quick cheat sheet:
Money you may want (or need) to use within five years should be kept in safe bank accounts. You won’t earn much, but the priceless trade-off is that your account won’t lose a penny either. “This is your ‘now’ bucket that you know will be there for you,” says Bibbo.
Your emergency fund is a key example of money that belongs in savings. If you are saving up to buy a car or home in the next few years , your down payment savings should also be in a safe bank account.
“Any money you would want to use within a few years shouldn’t be invested,” says Bibbo.
That’s because money you invest in the market always runs the risk of losing value over shorter periods. Exhibit A: Let’s say you had $10,000 invested in mutual funds in October 2007 that you intended to use for a home or car down payment in the next year or two. By October 2008, your $10,000 would have been worth around $6,000. That would have changed up your plans a bit, eh? If the $10K had been parked in a safe bank account, it would have been worth a bit more than $10,000.
Saving tip: Online savings banks tend to pay much better interest rates on savings accounts than your local brick-and-mortar bank.
Money you don’t intend to touch for at least 10 years should be invested in a diversified portfolio that includes a mix of stocks and bonds. (Check out our guide here to help you find the right mix.)
With a longer horizon, you can afford to ride out the market’s rough times so you can profit from the good times. Let’s say you invest in a mutual fund or ETF that mirrors the S&P 500. Over the past 90 years, the annualized return for that index is around 10%. To compare, right now you can get a little more than 2% in a high-yield savings account.
But you probably don’t want to go all-in with stocks. “To earn the really high returns of stocks, you have to live through some really uncomfortable periods,” cautions Peter Lazaroff, cochief investment officer at Plancorp in St. Louis, and author of the new book “Making Money Simple.”
That’s where owning some bonds comes in handy. Bonds are sort of like the middle child. They earn less than stocks, but more than cash in the bank. And when stocks are cratering, bonds tend to hold up well, with an average 5% return over the past 90 years. Owning some bonds in your long-term investing portfolio can calm your nerves when stocks are having a rough time, making it easier to avoid a common and very costly investing mistake .
Whether you should save or invest money you intend to use between 5 and 10 years from now is even more of a personal choice. “It’s a matter of how flexible you are,” says Lazaroff.
For instance, if you are determined to buy a home in five years, you should steer clear of stocks. “But if you are saying roughly five years, but you would be OK waiting eight years, then investing some of that goal money could make sense,” says Lazaroff.
Those few extra years would give your portfolio time to recover if the portion of your gray-zone portfolio invested in stocks takes a tumble. When a bear market hits (a period when stocks fall at least 20%), it typically lasts about a year , and then it takes another two years, on average, for stocks to get back to where they were before the bear market.
Not sure you’d be OK waiting that out? You can always play it safe, and keep more of that midterm money in savings.
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