Savings and Investments
As one of your regular expense items, you should include payments into a
savings (or investment) account (pay yourself first). A good
minimum savings goal is 10% of your gross income. The importance of this step
cannot be stressed enough; given enough time, it can literally bring you
financial independence.
A good guideline for knowing when you have enough savings and can begin
investing is to ensure you have 3 months worth of living expenses in liquid
savings (bank account, money market account, or short term CD) if yours is a
dual-income household. You'll want 6 months worth of living expenses if you are
the only breadwinner. Once you have your basic savings and have your retirement
covered, you can invest.
Investments
Once you are living below your means and building up savings, there’s the question of what to do with the money to create wealth. The following are some general investment categories in order from least risk to greatest risk.
- Bank account: CDs, checking, etc.
- Cash or money market funds
- Debt investments: bonds and bond mutual funds
- Common stocks and stock mutual funds
- Real estate
- Collectibles
- Options
- Futures
How Investment Categories Compare: Risks v Returns
Unless you’re a near expert in finance, collectibles, options, and futures are likely to be too high risk.
Real Estate
…is a very localized investment with more "negatives" than many realize and often not easy to sell on short notice (illiquid). However, it is - if bought, managed, and sold correctly—a great source of wealth.
Stock
…is probably the best general category to invest in for long term capital gain. Along with the increased reward potential comes increased downside risk in the short term. However, the risk of negative returns in stocks or mutual funds that invest in stocks decreases the longer they are held. Stock mutual funds are generally safer than individual stocks because of diversification and professional management.
Bonds
…usually have better returns than categories bank accounts or money market accounts and provide a good degree of safety. But know that within this one category the range of risk is wide, from junk bonds with the highest risk, to US Treasury bonds with the lowest.
Money Market Accounts, Bank Accounts, and CDs
…usually have returns that are near the rate of inflation. These are very safe, but do not afford a good return on your investment in the long run.
Allocating Your Investments
Once committed to investing, you should give top priority to setting your overall asset allocation. Basically, determine what portion of your investment capital should be used in each of three general investment categories:
- Cash
- Bonds
- Stocks
(When referring to stocks or bonds, mutual funds that invest in these securities are included.)
A traditional rule for calculating asset allocation is to subtract your age
from the number 110. The result is the percentage of your total investment
capital that should be in stocks; the remainder of your portfolio would be
divided between the other two categories in proportions dependent on your need
for income (bonds) and liquidity (cash). For example, if you are 40 years old,
110-(40)=70. So, 70% of your total investment would be in stocks and 30% would
be left to divide between cash and bonds.
Don't forget another important thing to plan for, especially if you are
self-employed - estate planning. See my article here.