You, my friend, are a part an elite group of savers in the United States. When you consider that, according to the Internal Revenue Service, one-quarter of American families don’t have any savings at all, you seem to be well ahead of the curve.
What are you setting money aside for? Retirement? Education? Or are you building wealth so you can someday jump into a silo filled with gold coins like Scrooge McDuck? Regardless of what you’re saving for, you should probably know a little bit about how these types of accounts work.
Unlike your typical savings account, investment accounts like a 401(k), IRA or brokerage don’t just hold on to your cash. These accounts convert your contributions into stocks, bonds and shares of mutual funds that, theoretically, earn you more than the interest rates offered at your local bank.
Many of today’s investment accounts make it really easy for people with almost no financial experience to start and keep saving. Minimal effort is needed to open and contribute to these accounts, and you don’t have to be a hedge fund manager to understand how your investments break down.
But, if you want to play a more active role in your long-term savings plan, we’re here to help you understand the basics. When it comes to how you should manage your retirement or brokerage account, there are three big questions to consider.
What Am I Saving For?
Saving for retirement and future education expenses are generally the two most common objectives of any long-term savings plan. While each objective can have their own unique savings products, tax considerations, and nuances, both require planning and some understanding of your goals.
If you’re saving for retirement, you should ask yourself when you plan to retire, how much money you’re going to need, and (kind of morbid, I know) how long you think you’ll be needing that money.
When saving for future education expenses, you need to have a sense of how much of your future children’s education expenses you plan to cover, how many children you expect to have and how much you think the average cost of a college education will be.
Answering these questions will help you figure out exactly how much you need to save, and it will help you formulate a strategy.
How Long Until You Need the Money?
The second question is a simple one: How long do you have before you’ll need to start drawing on your savings? This question is critically important in determining the aggressiveness of your portfolio.
Education and retirement are both expensive endeavors. How much time you have to save will dictate how much you need to save, and it’ll play into how aggressive you can, or should be, in achieving your goals.
How Do You Handle Risk?
Speaking of aggressive savings, how well you tolerate financial risk is the third question you need to ask yourself when evaluating your long-term savings plan.
Most of us working-class folks tend to get a little emotionally attached to our money and, sometimes, rightfully so. Oftentimes, we hear horror stories of hundreds of thousands of dollars in life savings evaporating almost instantly during a market downturn. Therefore, our risk tolerance tends to be a little lower than it should be, according to most financial analysts.
When it comes to investing, you portfolio is generally divided up into two investment types: stocks and bonds.
You’ve heard the expression “no guts, no glory.” This mantra holds particularly true when investing your money. The truth is, the higher the rates of return on your investment, the higher the risk is that you might lose some, or even all, of that investment. Stocks are the “risky” part of your portfolio, but with that risk comes a higher potential to earn more money.
While the individual performance of stocks varies wildly, the average stock investor can expect to earn between 6–7% back on their money, in general. But, with that, comes the risk that some or all of that money can disappear if the stocks in your portfolio perform poorly.
Bonds, on the other hand, are a much safer investment. While there can be risk associated with investing in bonds, it’s generally a lot lower than investing in stocks. But, the downside to that stability is a reduced rate of return. For example, the 10-year-Treasury bond currently returns around 2.6% per year.
It’s easy to keep them straight by thinking like this:
Stocks = Higher Risk, But High Rewards
Bonds = Lower Risk, But Lower Rewards
It’s Up to You
So, it all boils down to how safe you want to play it. Would you rather potentially earn more by investing in riskier stocks, knowing you could lose? Or, would you rather play it safe and grow your money slowly at a relatively lower rate of return? The answers to those three questions will determine how you should invest.
In general, the longer the time period you have, the more aggressive you can be. This allows you to weather the economic volatility of the market over the long haul. On the other hand, the closer you are to needing that money, the less risk you want to take, so maybe bonds are a safer play in that situation.
It’s always a good idea to consult a financial planner or professional before making decisions that could impact large sums of money that you’re investing. But, with a better understanding of what factors go into the decision making process, you’ll be able to make smarter decisions that could help you maximize your long-term savings plan.
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