Jeran Van Alfen, CFP®
Financial Essentials: Save Money in Cash or Invest?
When you think about your financial goals, you may be faced with conflicting priorities. You may feel like you should delay investing until you feel more established. You may wonder, should you save for short-term goals or invest for retirement? You may wonder, is it the right time to invest? Here are 3 important guidelines that you need to know.
Build a cash reserve first.
Before you invest for the long term, you should make sure that you have emergency reserves that are accessible without penalties. The amount of money that you hold in cash should be determined by your personal comfort level, but a good guideline is to hold the equivalent of 3 months to 6 months of your normal monthly expenses.
When you allocate money among asset classes, keep your time horizon in mind. Your time horizon is the time until you think you will need to use the money. Here is what I recommend:
Cash = 0 -2 year time horizon
Bonds = 2 – 4 year time horizon
Stocks = 5 year + time horizon
The objective is to avoid the situation where you need to withdraw money during a time period that you may have experienced a loss. Cash assets will protect your principal and make sure that your money is there when you need it. Bonds will typically earn a higher yield than cash, but may experience short-term fluctuations of principle, and Stocks will typically produce the highest returns but have the most volatility. Consider the chart below. On the left, it shows the expected time that it will take for the stock market to get back to its January 2022 peak. On the right it shows the average length of bull and bear markets. If the stock market were to average 8.3% annually, it would take 3 years for stocks to reach a new peak. During times like this, it is important to hold cash for your spending needs.
Now is a great time to review your cash savings!! Interest rates are higher than they have been in a decade, and you can earn near 4% yield on money that is protected from losing principle.
Know how to battle inflation.
While it is essential to build your cash reserve first, it is also important to understand the risk of holding too much of your money in cash. As I mentioned above, you should keep money in cash if you need the money within 2 years. However, the longer that you hold money in cash, the more risk you have of your money losing value to inflation. This means that while you may be keeping your money safe from market loss, you are still at risk of losing money.
Consider this chart that shows the long-term growth of various assets compared to inflation:
As you can see, during this time period T-bills (cash equivalent) lost money compared to the rate of inflation while both stocks and bonds outpaced inflation growth. When you are saving money for the future and especially investing your money for goals that are years away, it is essential to allow your money to grow. The best way to combat the effects of inflation is to invest in assets that will grow significantly over time.
Use your time wisely, it is literally money.
It can be tempting to put off investing, but just getting started is a win. The time value of money and the power of compounding will make a dramatic impact on the value of your portfolio, so it is better to start early even if you have to start small than waiting to invest.
Consider the following example:
Investor 1 is a 23-year old who invests $12k for 10 years and then allows the invested balance to grow without making contributions. (This assumes a hypothetical return of 8%) The investor reaches $1 million at age 54.
Investor 2 starts at age 33. In order to hit the $1 million by age 54, the investor has to invest significantly more and invest for a longer period of time.
Albert Einstein once referred to the power of compounding as “the eighth wonder of the world”1 As an investor, it is an important tool to build wealth for your future.
Create a plan.
Saving and investing for your financial goals comes down to making a few decisions. I recommend sticking with these 3 guidelines, writing down a plan, and reviewing your progress occasionally to make sure that you stay on track. Now is a great time to get started!
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Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.