Updated on 02.03.11

Saving IS Investing

Trent Hamm

One common question I get from readers appears in this type of email:

Dear Trent,

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.

Sally Saver

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.

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  1. kjc says:

    Real estate = “high return” ??

  2. Josh says:

    You’re right to say that the fundamentals of investing are spending less than you earn and setting goals, but in my view, that’s an incomplete statement.

    When you look at how individual investors perform, the picture you get is that the general public is buying high and selling low. If you cannot invest with discipline, then you will lose money like most of the mutual fund investing public.

  3. Jonathan says:

    to #1, kjc –

    Real estate can absolutely mean high return, if invested properly. It’s funny how real estate seems to have so fallen out of favor lately. But I’d take a real estate investment over a stock purchase any day. It pays high dividends (rent), holds its value well (the last couple years notwithstanding), and is a tangible asset with no chance of becoming worthless.

    This is especially true right now. In many parts of the country you can buy homes (as an example) for much less than it would cost to build them. We bought a very inexpensive house recently with 20% down, and the tenants now pay my mortgage, property taxes, insurance, plus hundreds of dollars in my pocket each month. That positive cash flow represents a 15% annual return on my initial investment (down payment plus small fix-up cost), and will continue regardless of the value of the home, which is nearly certain to go up (and to be honest, I don’t care if it does or not in the next 10 years).

    So yes, high return.

  4. CB says:

    If inflation weren’t part of the landscape, investing would be much easier. As it is, cash loses value if the return isn’t equivalent to inflation. “Your Money or Your Life” makes a good point about how inflation can be minimized on a personal level, and the gov. Inflation index isn’t applicable to many aspects of one’s life.

  5. valleycat1 says:

    Trent said: “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.”

    This is the only part of this wordy post that that kind of answers Sally Saver’s question. Nowhere does he really give any idea of the ‘how’ of investing.

  6. Gus says:

    My personal take on this:

    Investment: Something that you can do with your money where there is a reasonable expectation that your return will match or exceed inflation.

    That is, a savings account is NOT an investment. You know that your returns will not exceed inflation. Same goes for stuffing money in your mattress or for purchasing computer parts. You KNOW you will lose money. The question is how much.

    Is it a good start? Yes. Is it an investment? No.

  7. K Ann says:

    I’ve been a faithful twice a day reader for a couple of years now and realize that not every post can be sensational. However, I’ve found myself being disappointed more often lately than impressed with not only the post content but also Trent’s advice to reader questions. While I once highly valued the opinions given here, I’ve now begun to question and criticize routinely as I read. In this post I would agree with #5 valleycat1 that Trent’s answer given is hardly an answer.

  8. Jackie says:

    how how how. That question gets asked all the time and is never answered. Lets say I have the money and my fund all picked out HOW do it buy stock (or index funds or whatever)? Online? Through some investment house (Trent always mentions Vangaurd)? How do you contact them and what do you say so you don’t sound like an idiot waiting to be scammed when talking to the broker? Trent, these are the questions that Sally was asking and you continue to ignore. If you don’t know, then say you don’t know. Don’t give another lecture questioning if Sally really wants what she clearly said she wants.

  9. Telephus44 says:

    I also agree with valleycat1. Trent response fails to answer the question. Unless he’s trying to say until you know what you want, you shouldn’t be asking the question.

    Also – I really disliked this advice because it trivializes investing. It’s a very complicated subject, and giving someone the “you already are investing” answer isn’t helpful. How many times do we hear the advice NOT to consider your house an investment, but prepaying your mortgage somehow is? I know that investing is often seen as “the last step” in a personal finance journey, something that’s optional for experts who want more challenge – and that same attitude comes through here.

    On a basic level – if you’re really beginning – I’d recommend The Motley Fool website. They do a great job at making a complicaed subject easier to understand and more accesible. If you know the difference between a stock and bond, etc. I would read A Random Walk Down Wall Street. The Boglehead’s Guide to Investing is also good.

  10. Briana says:

    I do not have any “investments” other than my savings accounts (and CDs that are expiring). I am OK with this because I am very risk averse.

    #3 Johnathan – You are right. The problem is that because the average Joe cannot flip a house and make a mint it is called a BAD investment. The key is still discipline, like Josh (#2) said.

  11. AnnJo says:

    Money in a savings account is almost guaranteed to lose value after accounting for inflation, so I think calling it an “investment” is deceptive, since an investment should have at least a reasonable prospect of producing a gain. There are good reasons to keep a savings account, including protection against the (currently very small) risk of deflation, liquidity for emergencies or true investment opportunities and to build for specific goals, or because you just can’t find anything better to do with it, but it’s not much of an investment.

    Here is the advice I would give “Sally Saver” on investing:

    1. With the first $1,000 to 5,000, invest in “commodities” by taking advantage of sales and building a deep pantry of commonly used foods with long shelf lives and household supplies. If you go through one can of tuna a week and usually pay $1 for it, buy 200 cans when they’re on sale for 50 cents each. They have at least a 3-year shelf life, so you’ll go through them long before they go bad. On a $100 investment, you “made” $100, for a 100% rate of return. Do the same with a good variety of other foods and household supplies and not only will you make a better return than almost anything else could provide, but you will be well-prepared in the event of personal or community emergencies, will save time and money by making fewer trips to the grocery store, and have no risk of loss of your principal.

    2. Make sure you’ve “invested” in the high-value money-saving techniques Trent talks about, like weather-stripping your house, insulating your attic, servicing your car. A $10 4-pack of merino wool socks from Costco can return 400-500% if they allow you to lower your thermostat by a degree or two during the winter.

    3. Use 75% of the rest of your investable money in paying off ALL short-term debt that charges interest more than 2% higher than the current inflation rate (currently about 1.6%). That would be credit cards, car loans, etc. Use the other 25% to pay down on long-term debt, like a home mortgage or student loan. Think of that as buying a 30-year bond.

    3. While you are doing 1 and 2 above, study about investing. Read books by Benjamin Graham, Andrew Tobias, Peter Lynch, David Dreman, and a book or two about bubbles and scams, and learn how to read and understand financial statements (balance sheets, income statements and cash-flow statements).

    Once your short-term debt is paid off, you’ve maxed out your storage space on in-house commodities and built up an investing nest-egg, decide what market sector is currently out-of-favor and start looking for good investments there. Today that would probably be real estate but that requires some legal smarts, specialized knowledge, a fair amount of capital and a long time horizon, and can also take up a lot of time, so it’s not for everyone.

    Buy when people are in a selling panic, sell when people are in a buying frenzy, but only if you understand WHY they’re panicked or frenzied and are reasonably confident they are overreacting.

    Hedge your assessments. If you’re certain inflation is coming, force yourself to invest at least 10-20% of your investment money on the contrary assumption. If you’re sure the stock market is headed for a crash, force yourself to invest 10-20% on the premise of strong growth.

    Don’t fall in love with any investment and don’t let any one investment (or type of investment) become too large a share of your net worth (at least, without hedging it somehow).

    Be observant of economic and financial issues in your daily life and consider your observations in light of your investments. Are there fewer checker and longer lines at the grocery store along with heavier discounts on sales? Hmmm. What’s happening with that grocery company’s margins? Are they doing a better job of controlling costs and increasing their profit margins, or are they barely trying to survive on razor-thin margins?

    I know Trent is an advocate of simply buying index funds and holding them long-term. This assumes that, since the market is full of smart people whose profession it is to study these things, no small investor on her own can expect to beat the professionals’ returns. I’m skeptical (and it is not my personal experience) for this reason:

    The professionals (fund managers) usually MUST keep their money invested in the stock market and cannot simply go to cash when things get overheated. So not only will they take the hit of a market dip or crash, but when that happens they won’t have the cash available to “buy low” since that’s when their investors redeem. The small investor CAN do better, with discipline and study.

  12. Steve in W Ma says:

    There’s no way to answer Sally Saver’s question in one post. She basically needs to get some education, because there is no foolproof way to invest money and make a good return. I would suggest the recent book The Investment Answer as well as Andrew Tobias’s The Only Investment Guide You’ll Ever need to newbies.

    And, yes, if you are a hands-on person, real estate CAN be an investment. We’re talking about real estate that isn’t your house and which is bought according to invesment criteria involving ROI analysis.

    Again, Sally Saver needs to get an education, and one post from Trent isn’t going to do it.

  13. Steve in W Ma says:

    @ Josh, #2:”

    When you look at how individual investors perform, the picture you get is that the general public is buying high and selling low.”

    In many cases this is because the investor has put money that he/she can’t afford into noncash investments. In other words, the investor doesn’t have enough cash cushion to let him/her ride the wave.

    Having enough cash around so that if your noncash investents go down 20% you don’t panic is vital. Many investors, eager to increase the value of what they hold, OVERinvest and take on too much risk.

    Build a strong base, say, 15-20 thousand in cash. Then start investing in noncash sectors.

  14. I’m with AnnJo on this one.
    Food and Home storage would be a really good bet right now since we know that inflation is here is is only going to get worse for the next several months.

    Food, clothes, and household commodities are a smart place to start.

    Spend some money on your education, buy books and take courses.

    If you have a hands-on bend get some good tools: a table saw, sewing machine and the materials and knowledge to use them can provide secondary income.

  15. Mel says:

    To the people saying “he didn’t answer the question”, my reading of it was that it wasn’t an *actual* question, but a common question. “Sally Saver”?? So yeah, I think part of the answer *is* that before you know “why” you shouldn’t be worried about the “how” – and for a lot of people asking “how”, the answer to “why” is “because it feels like the next step I should take”.

    As for the “how”, it seems to me that it is a complicated answer. If Trent did write a step-by-step, it likely wouldn’t be comprehensive enough to be all that useful, and wouldn’t be relevant to a large part of his readership (those already investing, those outside US, those still struggling to get a positive balance). Which isn’t to say he shouldn’t write it, but there are better resources for that information.

  16. valleycat1 says:

    #15 Mel & others – I agree that ‘how’ is complicated, but Trent doesn’t even suggest some good books or magazines, or explain the different types of financial advisors, or websites that provide basic advice.

    Yeah, it wasn’t an ‘actual’ question, but the hypothetical one he presented was ‘how’ not whether we’re ready to invest beyond saving accounts.

  17. Sara says:

    I agree with valleycat1, Jackie, et al. that you didn’t really answer the question. I know it’s hard to give an answer to such a general question because it depends a lot on each person’s situation, but I think people who ask this are overwhelmed by all the options. They are probably comfortable with savings accounts, but looking to get started with stocks and bonds.

    My advice to people like “Sally Saver” would be to go to the web site of Fidelity or Vanguard and click the link to open an account. It’s pretty easy — you’ll just have to fill out some electronic forms. I would suggest opening a Roth IRA for the tax benefits, but you could open a non-retirement account if you prefer.

    You’ll need to transfer some money into your new account, and the easiest way to do that is electronic transfer from your checking or savings account. Fidelity of Vanguard will ask for your checking/savings account number in order to transfer the money. I believe Vanguard has a $3,000 minimum to open an account, and Fidelity has a $2,500 minimum, so you might need to save up for a while before you open an account. If you don’t have $2,500, Fidelity will still allow you to open an account by making automatic contributions of at least $200 per month.

    Once you have money in your new account, you will be able to select your investments. For the beginner, I would recommend either a target date fund (you can select a fund with your estimated year of retirement or perhaps earlier if you are planning to put this money towards a different goal) or an index fund (like the Vanguard 500 index fund or the Vanguard total bond market fund). These funds are more diversified than trying to pick your own stocks, so they are lower risk, but keep in mind that there is a possibility of losing money in any of these investments!

    There is no one right way to invest unless you are able to see the future, so you will have to do your own research to figure out what is best for you, but don’t go crazy trying to figure it all out before you start investing. You can do more research and change your investments after you open your account, but sometimes the hardest part is just getting started.

  18. Steve in W Ma says:

    @Jackie #8,
    Just call up Vanguard or Schwab and tell them you don’t know anything and want to know how you buy something through them. They aren’t going to scam you. The customer service reps there will be able to step you through exactly how you do something on their site (these days, almost all of your transactions will be done over the internet, or, as backup, over an automated phone system.)

  19. Bruce says:

    I hear many comments on here about inflation decreasing the value of your money. What is inflating that decreases the value of lets say $20K today? If you own a home I know that taxes tend to only rise every so many years, gas goes up, maybe even food. How does this decrease the value of $20K that will keep building as long as you keep adding to it? If all your going to save is $20K and think you can live off that in 20 or 30 years than that in itself is stupid thinking. If you keep saving from your income streams, that $20K could end up to be $500K in 20 or 30 years and no risk of it ever decreasing lime real investment vehicles. Keep in mind most incomes increase over the same period of time as inflation, so one would need to think about inflation in the first place.

    Besides saving money, the only investment I believe in is Real Estate. Yur money is not tied up in a computer, being stolen from by your investor, and other crooks that live in the computer world. The worst hasn’t come as of yet, and those blind in the dark will someday see the light.

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