Depending upon your circumstances and everyone’s is different, the order that you prioritize for investing may vary. However, in general most people should prioritize investing for the short-term and then the long-term. Short-term investing, which I prefer to call savings, is most commonly for an emergency fund. An emergency fund is basically a small accumulation of money to pay insurance deductibles and co-pays plus other small, unbudgeted expenses like a hot water heater replacement or new tires. An emergency fund should also be available as a replacement income during a time of unemployment. Most experts recommend having three to six months of expenses in an emergency fund. For many this may be the same as three to six months of income, but the distinction should be drawn here between income and expenses. To help evaluate how much you might need, look at the job market for your career. What you need to ask yourself is, “How long would it take me to find a replacement position to earn my current income?” Only you can be the judge, but that’s why three to six months is used as a rough guide. Statistically, the higher your income and the more specialized your field, the harder it is to replace your income. Some may want to plan for unemployment lasting more than six months.
Short-term savings may also include putting back extra for large purchases such as a large appliance, automobile, or vacation home. Though you may use similar instruments to help the money grow, be sure to keep this money separate from your emergency money. If you have the discipline to separate it through budgeting, you can use the same accounts, but this is difficult for most people. I recommend keeping separate accounts for your different short-term saving purposes. Obviously, it is difficult to save for your next car if you’re still paying on the old one, so debt elimination may be a factor in getting your short-term savings in place. Most would suggest getting a small emergency fund first, followed by debt elimination other than your home, followed by the rest of your short-term savings accumulation.
The objective of your savings instrument should be to outpace inflation while maintaining relatively stable principle values and high liquidity. We usually recommend a combination of a checking account, money market, and certificate of deposit for our clients. Each of these allows for good principle stability, but with varying degrees of return and liquidity. Having the least necessary in the most liquid investments is often the most advisable, but again only you can be the judge of what you will need access to.
In conclusion, the distinction between saving and investing is important. If you are merely “loaning” money with savings and not investing money, your assets will not truly “grow” in spending power. In fact, if you don’t keep up with inflation, the value of your money can go down even if the amount grows! Inflation is a real risk that should be considered for longer-term investing, so investment vehicles used for savings and investing should differ greatly for most people and businesses.
When it comes to investment risk, two facts are true for everyone! Everyone takes investment risk, but risk doesn’t necessarily mean return. You might be saying to yourself either, “I don’t take investment risk,” or “I like risk, it means more return.” Well, I’m sorry to say it, but if you are either person, you’re wrong. Now, before you become defensive, please let me explain.
First let me address those of you who think you don’t take investment risk. The fact is that if you have any money (or possessions), you take investment risk. There are many types of risk associated with money and possessions that people do not consider. If you say, “I don’t invest! I purchase possessions.” You incur devaluation risk. If you say, “I don’t invest! I put my money under the mattress.” You incur inflationary risk. If you say, “I only use certificates of deposit that are FDIC insured.” You incur Interest Rate Risk. If you say, “I only use government bonds.” You incur Reinvestment Risk. The point is regardless of how safe you think your money is, you are taking risks if you have any money or possessions anywhere. The fact of the matter is that life involves risk. If you are alive, you have taken risk, you are taking risk, and you will continue to take risk in all areas of your life including money. Let’s look at a few different parts of life to draw some analogies. Relationships. If you believe you don’t incur risks in your relationships because you refuse to have any, you take on a whole new set of risks. For example, you risk growing old alone. Transportation. You refuse to fly in a plane because you believe they are dangerous. Consequently, you take on even more risk by driving long distances and increase your chances of having a car wreck.
Perhaps you’re the person who believes that risk equates to reward. You must understand that all risks are not created equal. Regulatory Risk, Business Risk, Call Risk, Currency Risk, Market Risk, Liquidity Risk, Event Risk, Opportunity Risk (Cost), Political Risk, Operational Risk, Prepayment Risk, and those previously mentioned are just a few of the types of risk that exist. There are numerous risks that you may take for which you are not compensated, and there are other risks that you may take for which you are more likely compensated. Let’s look at some more analogies. Relationships. You only date persons who have a history of lying, but taking on this risk will not reward you with better relationships. Transportation. You understand the driving with no brakes is dangerous, so you disconnect the brakes to your car in hopes of getting to your destination faster.
These analogies may seem silly, but hopefully they help you to understand that every individual takes risks with their money and that all investment risks do not have an expectation of return. Over the next several weeks we will explore some of these investment risks so that you can make more informed decisions about investing your money!
For more information on investing, visit our financial planning page.