One common question I get from readers appears in this type of email:
My husband and I are finally on the path to financial freedom. We have only a debt or two remaining and have built up an emergency fund. We would like to start investing. Please tell us how.
When I read this email, I know what they’re looking for. They have money beyond what they feel that they need in an emergency fund that’s just sitting in a savings account and they’d like to feel as though they’re doing something more useful or productive with that cash.
The thing is, they’re overlooking the fact that they’re already investing that money. Simply having cash in a savings account is an investment!
Investing simply means that you’re utilizing a resource that you own or control with the intent of having that resource provide additional gains to you (or to someone else). Loaning $20 to a friend who is very thankful and promises to pay you back is an investment. You’re utilizing a resource you own or control (the $20) with the intent of having that resource provide additional gains to you or someone else (helping a friend through a pinch and perhaps accruing some social capital for yourself).
Money in a savings account is also an investment – you’re putting cash (something you won or control) in there with the intent of earning interest and keeping that money safe.
Most investments offer some amount of liquidity (the ease of which you can get back the resources you invested), some amount of risk (the likelihood that you’ll lose some portion of the amount you invested), and some amount of return (the resources you hope to gain from the investment).
Money in a savings account is an investment that’s very liquid (meaning you can withdraw and deposit largely at your heart’s content), very low risk (it’s FDIC insured and doesn’t put any of your balance at risk), and earns a very low return.
Because of this, when I see someone saying that they already have savings but that they want to invest, I have to assume that they’re seeking some form of diversification. They want an additional type of investment that’s in some way different than the savings they already have.
Usually, that means an increase in return, which usually comes with an increase in risk or a reduction in liquidity. Because they already have some amount of money in a low-risk form with low returns (that savings account), they want to add something with more risk to the equation in hopes of getting a greater return.
Thus, my answer to Sally Saver, after encouraging her to figure out why she’s wanting to invest, usually pushes her towards stocks or other higher-risk and higher-reward investments. In most economic conditions, I would include a suggestion to prepay on her mortgage as well, since that is also an investment from the perspective of someone who has already signed on the dotted line.
(Right now, though, a mortgage prepayment means that you’re only getting a bit better return (4% versus 1% or so in a savings account) for much worse liquidity (you’re only getting that money back at the end of the mortgage during those months when your house is paid off early or via a home equity loan). Although that’s still a solid deal, that’s not what people are often looking for.)
So, what’s the take home message here?
The fundamental act of saving is the key to all investing. By simply choosing to spend less than you earn, you wind up with a surplus. The more you choose to spend less, the greater your surplus.
As soon as you have a surplus, you’re now investing. What’s next? Goals. What are you investing for? Without that, investing is aimless – there’s no reason to choose stocks over a savings account because risk and reward have no real meaning if you’re not investing with purpose. You can only choose rationally and usefully among investment types if you know why you’re investing, when you’ll need that investment to come to fruition, and whether you can tolerate risk.
For example, if you’re saving for a summer home in ten years and your life won’t be a disaster if you have to put it off for a year, you’re probably well advised to invest in something with high risk and high return, like stocks or real estate. On the other hand, if you need to invest for your car replacement in 2012 and you know you’ll need a certain amount as a bare minimum by then, a savings account is the way to go so that you’re not risking what you’ve already got.
I think the idea of a savings account being a “default” investment is a good one. If you don’t have a goal but you do have a surplus, put it in savings – it’s low risk and highly liquid. This way, when you do figure out your goal, you know you can rely on what you’ve been saving and you know you can easily access it and put it to whatever ends you decide.
The fundamental pieces of investing are spending less than you earn and setting goals. Everything else is secondary.