Most of us have financial goals that fall outside of our day-to-day needs. Maybe we're saving for an upcoming birthday dinner, for example. Maybe we want to set aside money for a down payment on a new car or house. Or maybe we're saving money for our eventual retirement.
In my experience working with USAA members, I've found that a lot of people know they need to save. They just don't know how. One of the most common questions I get is: Should I invest my money, or should I save it in a savings account?
Because this great question presents itself so frequently, I recently wrote new lyrics for The Clash's classic song, "Should I Stay or Should I Go?"
Darling, please help my quest,
Should I save or should I invest?
If you give me just five steps,
I'll commit to do the rest.
So, you got to please suggest,
Should I save or should I invest?
Saving versus investing: Like many great financial questions, the answer is, it depends. On what? A little bit of math and some personal considerations. I'll walk you through five steps to help you decide whether to save your money or invest it:
- Identify your time horizon.
- Determine how much you can afford to save each month.
- Find the rate of return you'll need to reach your goal.
- Do a reality check, considering risk tolerance and risk capacity.
- Adjust your assumptions and commit to the plan.
Step 1: Identify your time horizon.
Generally speaking, investing is best for situations where you have more time to reach your goal — for example, saving for retirement versus saving for a birthday dinner next month.
Why should you invest when the time horizon is longer? Because you can take advantage of compounding interest, and you have the potential to outpace inflation.
It's important to remember, while stocks tend to outperform other investments over long periods, it's never a sure thing. There's no guarantee the market will perform well over your particular investing period — especially if it's short.
Step 2: Determine how much you can afford to save each month.
Take a look at your budget to determine how much you can afford to set aside every month. This number will tell you how hard your money has to work for you to reach your goal.
Let's say you want to stock your emergency fund with $5,000, and your time horizon is three years. If you can save $139 per month, then your monthly savings is doing the heavy lifting by itself. And you don't have to worry so much about finding a high interest rate.
On the other hand, if you want to have about $23,000 for a down payment on a new house in 10 years, saving $139 per month at 0% interest would leave you about $6,000 short. With that same monthly savings and time horizon, you'd need to earn about 6% annually to achieve your goal. This points more toward a stock market-type of investment.
Step 3: Find the rate of return you'll need to reach your goal.
Using the three inputs we've discussed — your savings goal, your time horizon and the amount you can save each month — you can now solve for the rate of return, which will help answer your "saving versus investing" question.
Imagine Jorge and Carla, middle-age empty-nesters who are worried about their retirement. Right now, they both work in their successful small business, which nets them about $180,000 per year. They want to retire in 20 years and hope to save $2 million in retirement between now and then.
One problem is that Jorge and Carla want to provide their daughter with a destination wedding in three years, which they expect to cost about $100,000.
So far, they've saved about $300,000 for retirement, which they've held in bank CDs that earn about 1%. They've set aside $60,000 for the wedding in their checking account that earns almost zero interest.
After some discussion, Jorge and Carla decide they can save $2,000 a month toward these combined goals. They plan to put $750 of that toward the wedding goal and $1,250 toward retirement.
To find their required rate of return, they use these inputs with an online calculator that can find the rate of return. The wedding goal would require a 5.6% rate of return and the retirement goal would require a 7.7% rate of return.
Step 4: Do a reality check, considering risk tolerance and risk capacity.
The words "safe" and "risky" can mean a lot of things in financial terms. But one is not necessarily better than the other.
When we refer to a safe investment, we're talking about something that's less volatile in terms of movement of the price or value of the asset. For example, savings account rates generally don't move much on a day-to-day basis. If you put your money into a savings account, you know the rate you'll earn and feel confident that you'll get your initial investment back. That's because some bank deposits are federally insured, up to certain limits.
Have you heard people talk about risk tolerance and risk capacity? While risk tolerance is how you feel about taking on risk, risk capacity measures how much risk you can accept. You could be risk tolerant but have low capacity for risk, and vice versa.
In the case of Jorge and Carla, when we do a reality check, we find that they're generally pretty conservative when it comes to investments. They're concerned about taking too much risk for the wedding goal. But they're willing to take on moderate risk for their retirement goal.
Step 5: Adjust your assumptions and commit to the plan.
Sometimes when we run the numbers and see the impact on our monthly budget — or what could happen to our hard-earned savings if the market takes a turn for the worse — we realize a need to adjust our plan.
Jorge and Carla talk with their daughter and agree to lower the wedding goal to $82,000. Instead, they focus more of their savings toward their retirement.
By lowering the wedding goal amount and reducing their monthly contribution to that goal, they discover they only need to earn about 1% in their existing bank savings account. By increasing their retirement savings to $1,450 per month, and extending the retirement date by two years, they would need to achieve a 6.4% rate of return.
Jorge and Carla are happy with this strategy and feel more secure knowing their money is safe in the bank account for the upcoming wedding.
Saving versus investing: 5 steps in action
Let's take it from the top with one more example. This time, we're working with Ellen and Max, a young married couple who want to save their money for a down payment on their first home. Ellen and Max have a combined income of $60,000, and they want to save $50,000. Currently, they've set aside about $2,000 toward their goal.
Here's how they'll arrive at their decision.
- Time horizon: Seven years
- How much they can afford to save each month: Between $400 and $500
- Rate of return they'll need: 9.2%
- Reality check, considering risk tolerance and risk capacity:
Ellen and Max are moderately risk tolerant and believe they have the capacity to take on moderate to high risk. They would like to stay within the seven-year time horizon. - Adjust assumptions and commit to the plan.
After playing around with the calculator, Ellen and Max find that by increasing their monthly commitment from $400 to $450, the required rate of return drops to about 6.2%. While there is no guarantee they will achieve this rate of return, Ellen and Max are comfortable with the level of risk involved and commit to their plan.
From these examples, it's clear that the question of "should I invest my money or should I save it" comes down to individual circumstances. Also, there are numerous financial solutions available once you know your goal's time horizon, how much you can save and whether the required rate of return matches your risk tolerance. Anytime The Clash's catchy tune pops in your mind, take the five-step approach to arrive at a decision that best suits your financial goals.
Want to achieve your savings goals?
USAA Bank can help.