Saving and investing are both important, but they serve different purposes. Although everyone wants to earn the long-term average returns of the stock market, the risk makes putting all your money there inappropriate in most cases.
On the other hand, while no one likes losing money, keeping all of your money in an FDIC-insured savings account won’t get you very far toward your long-term financial goals, particularly in the current low interest-rate environment.
But how can you tell when you should keep your money in the bank or invest in the stock market? Here’s a quick breakdown of what might tip the scales one way or another.
An emergency fund is the cornerstone of any financial plan. Having a sizable emergency fund can protect you from many of the unexpected financial surprises in life, from losing your job to encountering major medical or automotive expenses.
An adequate emergency fund also can relieve financial stress in your life, as you know that, no matter what happens to you, you’ve got funding set aside to protect you from going into debt. As an emergency fund must remain critical and intact, keeping these types of funds in the bank, rather than in the stock market, is the prudent course of action.
Generally speaking, retirement saving is a long-term goal. Unless you’ll be calling it quits within a few years, you can afford to take some risks with your retirement savings in pursuit of higher long-term gains.
Keeping your retirement money in a savings account isn’t likely to get you very far in terms of meeting your goals. On average, investing in the stock market is a much better way to earn sufficient gains to fund your retirement.
Simple math can spell out the big difference. If you put $500 per month in a high-yield savings account paying a 0.50% APY, after 30 years you’ll have about $194,000. That might not sound bad; but, if you instead put that money in the stock market and earned 10% annually, you’d have more than $1.13 million.
Since you have time to recover from temporary market dips over 30 years, the upside of the stock market is generally worth the risk.
If you start saving for educational expenses when your children are first born, you’ll have nearly 20 years before they’ll need that money. In that case, investing in the stock market is a solid strategy.
If you earn 10% annually in the stock market, your money will double just about every seven years. This means your college investment fund could potentially double two or even three times before your kids set foot in college.
But, as with retirement planning, you should take your foot off the gas as the first day of college draws near. At that point, preservation of what you’ve earned is more important than trying to eke out a few extra percentage points of return.
Vacation planning is usually a short-term savings goal. Although some planners may look a few years down the road, vacations typically are planned about one year or less in advance. With that short of a time frame, it’s not worth the risk to put your hard-earned savings into the stock market.
If you jump in right before a 20% downdraft, you would need to gain 25% just to break even — something that’s unlikely to happen in less than 12 months. The few extra percentage points you may gain on your vacation savings by choosing the stock market over a high-yield savings account aren’t worth the risk of losing the opportunity to go on your dream vacation.
Personal Risk Tolerance
At the end of the day, even if the stock market seems to be the better option for your investments, you’ll have to live with the volatility. If you simply can’t stomach owning investments that may regularly drop by 10% or 20% — and may at times fall by 50% or more — then you might need to dial down your stock market exposure.
If you have a long-term time horizon, you should have at least some exposure to the stock market. But strike a balance between investments that can help you reach your financial goals and those that allow you to sleep at night.
The Bottom Line
In a nutshell, most market experts recommend a time horizon of at least two to five years if you plan to invest in the stock market. If your financial goal is right ahead of you, the risk that you might encounter a significant market downdraft outweighs the potential to earn higher returns.
Over a 30-year time horizon, you’ll have the ability to come back from a market selloff. Over a one-year time horizon? Not as much.
But being too conservative may prevent you from reaching your financial goals. As “risky” as the stock market may seem, you’re perhaps taking even more risk by avoiding the market over a long time horizon.
Although the stock market regularly “corrects” by 10% or more, there has never been a 20-year period in which the S&P 500 has lost money. Looking at it from that perspective, there seems to be more risk staying out of the market than investing in it over the long run.
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