An initial priority of any financial plan is to build up your cash reserve. It is extremely important to put money into savings so that you have money when you need it the most. Typically, you will hear recommendations to have the equivalent value of anywhere between 3 months and 9 months of monthly expenses saved up in cash. So, you may be doing a good job and building your savings, but where should you put it? With the average savings account providing an interest rate of 0.06%, you may need to consider some alternatives to just keeping your money in the bank.
What is the risk?
Many savers keep their money in cash accounts like savings, money markets, or certificates of deposits (CDs) in order to keep their money safe from loss. These accounts are not exposed to fluctuating markets and most likely are guaranteed by the FDIC.
However, there is still a risk that exposes your cash accounts to losses over time. This risk is inflation. If money sits in a cash account over a long period of time, the value erodes to inflation. When you add taxes on the interest that you earn in cash accounts, it is most likely that your long-term real return on your money will be negative.
It is still a good idea to keep some money safe from market losses if you plan on using it soon. I recommend following these guidelines to determine where you should put your savings:
Short-term Savings
If you plan on using the money in the next 0-2 years, keep the money in cash. If you are going to buy a house an need a down payment soon, if you are saving money for a large expense that is coming up or if you need a cushion to fall back on if you are concerned about your income, these are all examples of reasons to keep your money in cash. When you need money the most, you don’t want to worry about your balance being down because of a loss to investments. This is your safe money.
Even though I recommend keeping the money in cash, I recommend looking for the highest yielding cash instruments. High-yield savings accounts are typically offered by online banks and provide more interest than the regular savings account while still providing FDIC insurance.
Mid-term Savings
If you plan on using the money in the next 3-5 years, consider using fixed-income investments like bonds or bond funds. This is money that you want to keep safe, but you really don’t plan on using it anytime soon. Since you don’t want your money sitting in cash for too long at low interest rates, you may want to consider taking a slight amount of risk with the money to earn a higher return. Bond instruments typically offer lower volatility than stocks while also proving consistent interest payments. These types of investments may offer stability in the 3 to 5-year range with better returns than cash.
Long-term Savings
If your saving money for goals that are beyond 5 years away, I recommend using stocks or stock funds. Stocks consistently provide long-term average returns that are higher than bonds and cash. I only recommend investing in stocks for goals that are beyond 5 years away because in the short-term, you can see drastic fluctuations in stock prices that may result in a loss if you withdraw your money. However, if you are trying to grow your money for a long-term goal, stocks may provide the best results for you to accomplish your objective.
Building a Diversified Strategy
Follow these simple steps for allocating your savings:
Determine your target values: How much do you need in cash? How much do you need for future goals?
Find the right cash account: Put your money in an account that is paying you a good yield.
Open a brokerage account for additional savings: A brokerage account will allow you to access investments to mid-term and long-term goals.
Automate your savings process: Set up automatic monthly contributions to your diversified savings accounts.