The Importance of Investing – Moving from Savings to Investment

by Sean (@financefitz) on June 7, 2012

in Savings & Investment

Big Idea – The Personal Finance Decision Process – Investing Your Excess Savings
Objectives – Readers will be able to –
  • Explain the importance investing.
  • Calculate how inflation decreases the return on investments.

Laying the Foundation for Investing

People typically want to start a personal finance discussion with the topic of investing.  Investing is the process of purchasing assets with the goal of increasing wealth.  Before I have an investing conversation I usually ask the following:

  • Do you have any recurring credit card debt?
  • Do you have an 8-12-month emergency savings fund?

Often, people have credit card debt and do not have a proper emergency savings fund.  I advise them that they should not invest aggressively until they lay a proper foundation, which includes an emergency savings fund and paying off high interest credit card debt.  These “investors” cannot risk losing the money that they have.

Most people need to spend more time making proper savings versus spending decisions prior to investing.  You control your spending and saving decisions, but you do not control the stock, bond, and other investment markets.  With that said, I want to explain the importance of investing, as earning investment income can help you reach your financial goals.

The Importance of Investing

Savings accounts are currently paying Average Percentage Yields (APYs) around 0.2%.  Inflation has averaged around 2.7% over long periods of time. When not outpacing inflation, your purchasing power is declining.  Under this scenario, excess savings parked in the savings tools will not help you enhance your wealth.  Excess savings is defined as money that is not part of your emergency fund, or money that do not need for at least 2 years.

For individuals who have met the prerequisites of paying down high interest debt, and establishing an emergency savings fund, you are ready to invest and grow your money.  In Rules to Becoming a Millionaire – Growing Your Money, I discussed the three most influential things that influence the growth of your money:  time, investment value, and rate of return.  The earlier you take care of these prerequisites and start investing the better the opportunity for your money to grow.  Based on historical returns, leaving too much of your excess money invested in low interest and low risk investments will not help you significantly add to your wealth.

Why People Should Consider Investing Excess Savings

At retirement or nearing retirement -

One of the biggest problems in today’s economy is that interest rates on savings balances are low, and investors are not generating the returns that they need to grow their assets and meet their retirement and financial goals.  I have heard complaints from people nearing retirement regarding how they have had a decline in their net worth from the economic crisis.  Given this, they fear taking risk.  Some have decreased their normal allocation to stocks and increased their allocation to U.S. Treasury Securities at record low yields.  Though these securities are considered safe for buy-and-hold investors, the annual return is low.  The paltry yields from savings accounts, 2-year Treasury Notes, and 10-Year Treasury Notes have been hovering around 0.2%, 0.25%, and 1.53%, respectively.   For retirees, who depend on a fixed income and are used to earning 5% a year, this makes it increasingly difficult to meet expenses.

Younger investors

The conversations I have had with younger investors confirm what many surveys indicate – investors are underinvested in stocks and “risky” assets, and are keeping a lot of their excess savings in low-yielding short-term investments as they fear investing in the stock market.   Many investors are keeping most of their money in highly liquid, low-risk interest bearing accounts due the fear induced from the collapse of the stock market during the financial crisis.

If you stuck out the stock market roller-coaster ride of 2008-2009, or invested more for the long term when stocks were low, good for you.  If you are on the sidelines and are pre-retirement, you need to consider the following:

  • Survey your risk tolerance, goals, time horizon, and asset allocation.
  • Underinvesting over the long-term can significantly diminish the probability you will increase your wealth to meet your long-term financial goals.
  • If you find yourself underinvested based on your risk appetite and factors, or that you are deviating from your long-term plan, consider changing your allocations.

Two (of many) Reasons To Consider Investing Excess Savings

Reason 1 - Inflation Will Eat Away At Your Money and Decrease Your Purchasing Power

Assuming inflation averages 2.7% going forward, your money in a low interest savings account or short-term fixed income investments will have a difficult time outpacing with inflation.  With the CPI-U (Consumer Price Index) around 2.7%, and with savings account and longer-term CD APYs ranging from 0.20% to 1.75% consider the following:

  • You are losing money currently, as your real return is negative.
  • Your purchasing power is declining.
  • Even if you can eventually earn 2.7% in a savings account, money market account, CD, or Treasury security, when inflation averages 2.7% your real wealth is unchanged.

The following example highlights the importance of investing excess savings:

  • Today, you are considering purchasing a car.
  • Assume you have $20,000 and don’t want to take out a high interest loan to finance the car.
  • Thus, you are going to pay cash.  You have two options:
    • Option 1 - Deposit the cash in a 1-year CD earning 1.5% and then purchase the car in one year.  Assume inflation and the price of the car will go up 3% next year.
    • Option 2 – Purchase the car now.

What option would you choose?

You would buy the car now for $20,000 for the following reasons:

  • If you don’t buy the car today and put $20,000 in a 1.5%, 1-year CD, your money grows as follows:
    • Initial deposit – $20,000
    • Interest earned – $300 ($20,000*.015)
    • Total balance after 1 year –  $20,300
  • The car’s purchase price after one year will go up by 3%.
    • Price today $20,000
    • Price increase – $600 ($20,000*.03)
    • Price in a year – $20,600

If you do not buy the car today, and you wait to buy it in a year the results are the following:

  • You are $300 short as the 3% increase in the price of the car was 1.5% greater than the interest rate you earned in your 1.5%, 1-year CD.
  • You earned a negative real return (-1.5%).
  • Your purchasing power has declined.

Inflation is that hidden thing that decreases your purchasing power.  This  was an oversimplified example over one year, and it really should be evaluated over the long term.  Over the long term, it is important that you invest your excess savings to at least outpace inflation, as this will increase your net worth and enhance your purchasing power.

Reason 2 – You Will Need 60-70% of Your Pre-Retirement Income When You Retire

Financial advisors estimate that you will need 60-70% of your pre-retirement income when you retire.   If you are making $40,000, at 65% you will need an estimated $26,000 each year.  Using a conservative annual return of 5% this implies the following:

  • You will need about $420,000 to withdrawal $26,000 each year over 30 years.1
  • You will need approximately $226,000 if you are supplementing your retirement with $1,000 each month from Social Security or a pension.

Products and Historical Returns

Your retirement goals pertain to your needs, wants, and preferred lifestyle, and those factors differ for all investors.  Given your goals, it is important that you understand the importance of investing and the historical returns of different products.

Long-term average returns for various investments are no indicator of the future performance.   But, for our purposes, it will help you estimate how long it will take your money to double if you invest and earn historical returns.

There are many more investments to analyze, but for simplicity let’s look at three investments.  From 1928-2011, stocks averaged a compound annual return of 11.20%, U.S. 10-Year Treasury bonds averaged 5.41%, and 3-month Treasury-bills averaged 3.66% before inflation and taxes.2   Using the Rule of 72, which takes the 72 divided by the annual return, investors can estimate how long it takes money to double if they achieved the historical returns.

Investment Rate of Return Before Inflation Years for the Initial Investment to Double Using the Rule of 72
Stocks 11.20% 6.42 years
U.S. 10-Year Treasury Bond 5.41% 13.3 years
3-month Treasury-bills 3.66% 19.67 years

 

Looking at the table, you can see that stocks have had the highest annual return historically, and intuitively your money doubles more quickly.  A 3-month U.S. Treasury bill has a lower historical return and your money takes 3 times longer to double on average.

In closing, remember the following:

  • Investing will help you reach your long-term financial goals and outpace inflation.
  • There are a variety of tools that can help you grow your money, but it is recommend that you do a complete review of your financial situation, risk tolerance, and goals before allocating your assets and choosing investments
  • There is no free lunch – a higher potential return is associated with a higher risk.

The question I will help you answer in future posts -  How do you invest to meet your retirement goals?

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Upcoming post-

Bond Basics – How to Make Money Investing in Bonds (Part 1 of 2)

 

Assessment (answers in tomorrow’s post) -

1. What are a few risks of underinvesting?

2. What are a few prerequisites of investing?

3.  Leave a comment regarding a general investing question you would like answered.

4.   How much annually do you need in retirement assuming your current annual income?  Assuming you will live for 30 years and will withdrawal the same amount each year, how much does that imply you will need at age 65 assuming 5% annual returns?

Calculator-

http://www.money-zine.com/Calculators/Retirement-Calculators/Present-Value-Annuity-Calculator/

Answers to yesterday’s questions-
1. What is the risk of today’s low interest rate environment?
If inflation is rising by 2% and you are earning 0.2% on your savings account, your purchasing power is going down by 1.8% each year.  In a sense, you are making yourself poorer with each passing day.  Thus, the risk is that you are not keeping up with inflation.
2. What is the difference between a money market account and a money market fund?
A money market fund is not FDIC insured and a money market account is FDIC insured.  Money market funds typically invest in short-term U.S. Treasuries and short-term commercial paper, and other investments with average maturities less than 90 days.
3. Use the tools provided to research current savings rates.   Compare the APY you are earning on your existing savings with current market APY.  Determine a plan of action to maximize your return for the level of risk.  Please share any information that will help our readers in the comments and on the Personal Finance Teacher page.

 

Sources –

1 – Used calculator at estimatepension.com

2 – Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histret.html#_msoanchor_2

3 – Retrieved from moneyzine.com

 

 

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