Quite often, I’ll get emails from readers saying that they’re looking to invest their money and that the money they want to invest is currently sitting in a savings account. What these readers often overlook is that the money in their savings account is already invested.
An investment simply means that you’ve put aside a resource for future use with the hopes of gaining a return on that money. A person can invest in anything from baseball cards and stamps to real estate and stock investments.
I usually look at three big factors when thinking about an investment.
Rate of return How much of a return on my money can I reasonably expect with this investment? For example, over the long term, a reasonable rate of return to expect from a broad stock market investment is 7%. If you invest in a savings account, a reasonable rate of return is about 1% right now.
Risk How likely is it that I’m going to get the return I expect with this investment? With stocks, there’s a significant amount of risk, particularly over the short term. If you bought heavily into stocks in early 2008, you probably lost 40% of your money. On the other hand, if you put your money in a savings account in any year, you had a small positive return, just like clockwork.
Liquidity How easy is it for me to get my money out? Savings accounts are incredibly liquid – all you have to do is visit an ATM. Stocks are a bit less liquid, but you can usually sell them quite easily through your broker. Other things, like real estate or CDs, are not very liquid, as you incur losses for cashing out a CD early and real estate sales require a buyer before you can get your money out.
As you can see, a savings account registers on all of these factors. A savings account is a highly liquid, very low risk investment with a low expected rate of return.
You can make similar statements about a lot of investments. An index fund of all American stocks is a highly liquid, moderately risky investment with a medium expected rate of return. Vintage baseball cards are a fairly illiquid, moderately risky investment with a medium expected rate of return (based on my experience). A CD is a fairly illiquid, very low risk investment with a fairly low expected rate of return.
The question then becomes how do you decide where to put your money? Again, I use a few simple rules of thumb to compare the investment types.
The sooner I need the money, the less risk I’m willing to accept. If I’m saving for retirement, I’m fine with significant risk. If I’m saving for a car I intend to buy in six years, I’m fine with some risk. If I’m saving for an air conditioner repair in five months, I don’t want much risk at all.
If I’m going to possibly need the money quickly, I need it to be pretty liquid. In other words, I would not put my emergency fund into real estate or collectibles, nor would I put it all into a certificate of deposit. These investments have their place (a long-term goal), but they’re certainly not for everything.
If I absolutely must hit a certain dollar amount at a certain time, I’ll lower my risk and focus on raising contributions. For example, if I have to have $100,000 to pay off my ARM in four years, I’m not going to want to put that money in a risky investment where the balance can unexpectedly slip away from me. I’d rather put it in something with a lower rate of return with much lower risk and focus on increasing the amount I can save.
Rate of return rarely plays a role in these decisions. I generally focus on liquidity and risk first and foremost, and when I have those figured out based on why I’m investing, I try to find the best rate of return for that amount of risk and liquidity.
Thus, quite often, savings accounts are my preferred investment vehicle.