Last week I wrote about steps to complete before investing, as I think about how to talk about investing and personal finance to the residents at my program. I started writing about all the things that really need to happen before a person is in a good place to invest, and it ended up taking a long time and many pixels.
Something similar happened this week. I had planned to cover proper investments in this post, but got caught up in explaining why just saving money isn’t enough. I’ll see if I can get to investing next week.
Stash of Cash
Last week I wrote about saving money before you invest. After all, if you don’t have any money set aside, you can’t really invest it.
I may not have said it explicitly, but I strongly recommend putting those savings in an account at a bank or credit union.
Cash in a savings account has been a pretty safe place to keep your money for decades. It is safer than keeping it hidden at home–no worries about someone breaking in and stealing your stack of cash from under your mattress. Or worse yet, having someone help you clean up, and throwing out or donating your money.
Since the formation of the FDIC (Federal Deposit Insurance Corporation), most bank accounts are insured up to $250,000. That is to say, if you have a savings account of less than a quarter million dollars, even if your bank goes out of business, your money is insured, and will be returned to you. If you have money in a bank, you should make sure the bank account is FDIC insured.
A credit union is another place to keep your money safe; strictly speaking, your savings account may be called a share, as in, you own a share of the credit union. In any case accounts there won’t be covered by FDIC insurance, but should be covered by the National Credit Union Share Insurance Fund (look for a sign that the credit union is backed by the NCUA, or National Credit Union Association). The $250,000 limit is the same as at banks.
Interest-ing Issues
In addition to keeping your money safe from thieves and cleaning help, banks often will pay you interest.
Why is that?
Banks need to have reserves. They make their profits from lending money and charging interest; however, most banks are required to have deposits of some fraction of the money they loan.
In order to reward people for depositing money with them, or to encourage people to trust them with their money, banks pay interest on deposits. As long as the interest paid on deposits is less than the interest charged on loans, the bank can make a profit.
When I was growing up, most savings accounts paid 5%, and maybe even a little more.
Nowadays, a 2% return on your savings is a good deal.
more interest
If you want to earn a little more interest than you can get with a regular savings account, you can get a CD, or Certificate of Deposit. Basically, you give the bank money, but instead of being free to withdraw it at any time, you agree to have it locked up for a set period of time. This lock up period or term usually ranges from 3 months to 5 years. The bank knows it can count on this money for a set period, and to compensate you for the inconvenience, they give you a higher interest rate. If you decide you must have your money back before the end of the term, you will forfeit all or some of that interest you were promised.
You might also have heard of money market funds. These are accounts offered by investment companies. They are like cash, but aren’t really. You buy shares (or fractions) in a fund that invests in short term securities. The ideal is that the value of 1 share is always at least $1. However, this is not guaranteed, and you don’t have insurance on this sort of fund the way you do with a bank or credit union account.
Nevertheless, these funds are usually quite safe; there have been only a few instances of “breaking the buck.” When that happens, you lose money, as your $1 share is now worth less than one dollar (so $1000 yesterday might be worth only $960 under these circumstances). Companies try very, very hard to keep this from happening, and it happens only rarely.
Why Savings accounts aren’t enough
You might ask, if I can earn money on my savings, in a pretty safe way, why can’t all my money stay in the bank? The answer is: inflation.
As a reminder, inflation is the phenomenon of finding that over time, the price of things goes up. Or, to put it another way, the same dollar buys less.
So if you plan to spend $100 a month on groceries, and inflation is 5% a year, then next year you will need to spend $105 to buy the same month’s worth of groceries. The year after, you will need 1.05 x $105 or $110.25. And so on. In 20 years, if inflation continues on at this rate, you will need $265 to buy the same groceries.
If inflation is steady at 5%, and you can get a 5% interest rate on your savings, you’ll be all set. $100 saved now will buy you a month of groceries whenever you need it.
If inflation is 5%, and you can get a 6% interest rate on your savings, you will be ahead of the game. Put aside $100, and you can buy groceries anytime you want, and maybe even a magazine at the checkout counter, if something catches your eye.
However, if inflation is 5%, and you are only earning 2% on your savings, you are falling behind. $100 now won’t grow enough to buy your groceries in a year or two. In 20 years, at that rate, you’ll either be going hungry, or changing what you buy at the store.
saving vs investing
The idea behind investing is having your money grow so that you have more purchasing power over time. This means the scenario where your investments earn more than inflation is eating up. You want to be able to buy groceries and silly magazines (if they still sell them) when you are old.
These days cash or savings accounts aren’t really great investments. That wasn’t always the case.
When I was growing up, you could keep money in the bank and get paid 5% to keep it there. Inflation had some awful spikes in the early ’70s, but from 1983 on, the inflation rate has mostly been less than 5%, sometimes significantly less.
Nowadays you are lucky to 2% at your local bank; in a checking account, you might be getting 1/100th of that rate. Meanwhile, inflation in 2018 was over 2% most months.
Therefore, if you want your money to grow –that is, to give you more purchasing power over time–you will need to invest.
Save the savings account
Does this mean you should ignore all the advice I wrote last week about having emergency funds? I don’t think so.
As I wrote last week, the utility in having emergency funds (little “e” and capital “E”) is knowing that the money is safe, and will always be available.
The money you will be investing can grow far faster than inflation, but you also run the risk of having it lose value. Finding out that your $1000 has turned into $800 isn’t very helpful when you have a surprise bill.
Next week, work permitting, I will finally get to talking about investments, or at least some types of investments.
What do you think? Am I taking too long to get to investments? Do you think residents already know all this? Do you think I forgot something?