If you have ever had a conversation about money with anyone
they have probably told you that saving your money is a good idea. While I
cannot argue against that point I can say that just saving your money is the worst of the good ideas out there.
Your
savings should be anywhere from 3 to 6 months of your living expenses in liquid
assets, anything that is cash or can be sold easily for cash with little or no
effect on its value. Yes, that does sound like a lot because it is and it is
for a good reason. Here is a short list of monthly expenses (depending on
lifestyle) $1000 for rent, $300 for food, $250 for health insurance, $150 for
gas, $120 for electric, $80 for cellphone, $60 for car insurance, $50 for
internet, and $20 for property insurance. This is a rough estimate and it is
just considering you are single, healthy, have zero debt, and have no
dependents. The grand total is $2,030 a month, 3-6 months of that could be
anywhere from $6,090 to $12,180. This may seem like a lot of money sitting
around not doing anything because it is.
Having
the emergency fund is important to help you navigate those obstacles in life like
losing a job, major car repairs, or a serious injury without having to dip into
things like your retirement accounts. However, having that money sitting in a
savings account is almost the worst thing you can do with it besides spending
it on non-emergencies. Savings accounts accrue almost insulting amounts of
interest, sometimes as low as .01%.
Having
large amounts of cash in a savings account is detrimental and in the long term
will cause you to lose money. There is this nasty thing called inflation, it
has been around forever terrorizing peoples savings accounts. Inflation causes
your money to lose value, essentially it won’t be able to buy as much in the
future as it can now. Currently the average rate of inflation from 1913 to 2013
is 3.22%. To give you an idea of what this does to your money; If you currently
had 3 months of expenses saved, $6,090, you would have to have $8,399 dollars
to purchase the same amount of goods 10 years from now. While your money won’t
be disappearing, you will find out later that it won’t be able to buy as much.
This can
be very discouraging but I am happy to tell you there are plenty of things you can
do to negate the effects of inflation. The basic idea is to buy an asset that
can appreciate but can also be sold quickly enough to provide cash to cover
emergency expenses. These assets are liquid assets or something that can flow
in and out of the state of cash without losing too much of its value. There are
plenty of these types of assets available, however there are certain types that
are better than others for mimicking a savings account. The qualities you want
to look for in assets; 1. They can be sold relatively quickly without major
depreciation in value or penalties; 2. Has a history and a predicted future of
low volatility; 3. Has a yield that is close to or above the rate of inflation.
The first
is the most important because the whole purpose of having savings is so that
you can cover unforeseen expenses. If the assets you are invested in can’t be
sold quickly enough or without penalty then they really aren’t serving their
purpose and should be used for something else. This does not mean you should
have all cash because if you did and you never run into any large emergencies
you miss out on the potential profits that could have come out of that money. It
also does not mean you should have zero cash, there are many instances when
cash is necessary instantaneously such as over drafting your checking account
or something as crazy as a once in a lifetime investment opportunity. Bottom
line a good amount of cash would be that of an expensive yet realistic car
repair or at least the largest amount that could potentially be over drafted on
your checking account.
Low
volatility while being second inline is a very close second, any asset you do
purchase will have some sort of risk involved in it. One dollar will always be
one dollar but a piece of gold bought for one dollar will not always be worth
one dollar. Having said that the purchasing power of one dollar will rarely if
ever increase but the amount that asset, like gold, could be sold for an increase
in value at some point. The big downside is that when you do purchase an asset
it can at some point lose all or most of its value, the chance of this
happening is its volatility. One example would be if you owned Enron stock at its
height of about $90, close to a year later it would be worth $.50. Therefore,
you want to buy an asset that has a history of low volatility and a predicted
future of the same. While this is an extreme case it is a good example of why
the asset you buy should not be stock in publicly traded company. You should
buy an asset that has very little chance of entirely losing its face value.
The
yield, or growth of the asset is the last thing you need to look for. It should
be close to or above the average rate of inflation. While this is the main
point of buying a financial product in this specific case, it cannot be the
main determinant when selecting that product, do not get greedy. The bigger the
possible gains the asset proposes it probably has equally as bad possible
losses. Now that we know all these things the idea is to get as close to the
risk reward breaking point as possible while maintaining that liquidity that is
so important.
Now we
get to the proverbial question “What do I need to buy?” While I have suggestions,
I like to leave this up to you because everyone’s situation is different. I
will give you the pros and cons of the three main options and tell you which
one that I would pick. After all the best way to get to financial independence
is by making your own decisions.
The easiest
and safest thing you could do is invest in a money market account. These
accounts are like savings accounts but generally have a slightly higher interest
rate. They have the safety of an account that is FDIC insured and are
in-volatile, but this comes with a price, you will still be losing in the long
run to inflation. Their interest rates while higher than savings accounts are
generally never above 1%. If you decide to use a money market fund I would
suggest that you do not put all your cash into it unless you must do everything
possible to maintain its current value while still earning a bit of interest.
The
harder of the riskier options would be investing in fixed income products like
CD's, Bonds, Annuities, and Treasury Notes. These investment products do have a
much higher yield than money market funds but in some cases, are more un-liquid
or not able to be used in an emergency. They are also slightly riskier
especially if they aren’t issued by the U.S. Government. The benefit is that it
requires a lot of research to find the right asset to buy. This gives you the
chance to learn about major financial players in our economy which will
hopefully give you knowledge that can lead you to making other informed
financial decisions. In the financial world knowledge is money.
This
brings us to our last option, the easier of the riskier options, and the one
that I think is all around the best, Bond Funds. These are essentially just
like mutual funds made up of stocks but are made up of bonds that are issued by
companies or government agencies. The financial wizards that manage these funds
do all the heavy research for you and you get to reap all the benefits. The
benefits of bond funds are the perfect blend of yield and risk level because
they are usually sell-able without penalty and the proceeds can be used
relatively quickly while still having the low volatility of fixed income
assets. The returns on these funds are not anything to get excited about but it
is easy to find one that meets or exceeds the inflation rate. The only concerns
with them is that they do tend to fluctuate in value especially with the
movement of interest rates in our economy and they have expense ratios. These
are amounts of money that you must pay to those that manage the fund you
decided to invest in, however it is also easy to find a bond fund that has
substantially less than a 1% expense ratio.
If it
were up to me I would buy a bond fund that is comprised of government backed
securities which would give me very predictable interest rates and relatively
low risk. But I won’t rob you of making your own decision. One of the best
feelings is taking your future into your own hands and that goes for your
financial future as well. Now that you have some of the facts you can make the
right decision for yourself, just try not to stress about it too much, the
worst decision you could make is to do nothing and let inflation eat away at
your savings.
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