Saving & Investing: An Overview
By Leo Babauta
When we talk about reducing and eliminating debt, we have to include a discussion of savings and investing.
Why? For several reasons:
- If you don’t have a savings, reducing debt will be a much bumpier ride (if not almost impossible) because every time an emergency comes up, your debt reduction payment will be used. Savings is a crucial component to debt reduction.
- Debt reduction is only part of the picture of sound financial health. It’s a great start, but you’ll want to think beyond that eventually, to having healthy savings and investments.
- Most people think savings and investing aren’t that important, and so neglect them. They’re important. Don’t neglect them for too long.
The sooner you get started with these areas, the better. They pay off big over the long term, so starting sooner means a bigger payoff later.
I won’t be able to cover everything in one article, but let’s at least cover some of the basics to get you started, and you can do more reading on your own later.
The habit of savings is a big part of the habit of debt reduction, and the healthy financial habits you want to build for life.
Here’s what I recommend:
- An Emergency Savings Fund. If you don’t have even a small emergency savings fund yet, this is a top priority, maybe the top priority. It’s incredibly hard to do debt reduction without even a small emergency fund. What’s a small fund? At least $100 to start with. If that seems impossible, cut out a few expenditures, and just start with $25 or $50, then add to it next paycheck. If you don’t have a separate savings account, start now. If $100 is easy, shoot for $500. Then $1000. This is the starting point. If $1000 seems impossible, start with $100 and then shoot for $500. It’s all relative to your income and situation.
- Make savings automagical. Once you’ve gotten a small fund started, add to it each payday by putting in a small amount automatically. Set this up online at your bank’s website. Even just $25 to start with is great. Shoot for 5% of your paycheck, or even 10% if that’s possible. But put it on automatic, and don’t touch it. If you touch it, it should be to increase the amount when you can afford to.
- Grow it to at least a month’s worth of expenses. Many experts recommend 6 months’ worth of expenses, and that’s an awesome goal eventually. Don’t worry about that now. Eventually I think you should have at least a month or two of expenses in your savings, and then even more in investments. Investments are better than savings overall, because (on average) they grow faster than savings, so it’s a better use of your money. But you’ll still want savings, even after you’ve gotten into investments, because it’ll help you pay for small things that come up. Savings help smooth out the bumps in your finances.
Once you’ve gotten that going, move on to investments.
As mentioned above, investments are the best use of your money, because they grow your wealth more than savings (and both are tremendously better than debt or just spending on needless things). But investments tend to be a scary area for many people, mainly because they don’t know much about it.
Investments can be very complicated, but they can also be pretty simple if you just stick to what you need to know. That’s what I’m going to concentrate on.
First: what are investments? I recommend reading The Little Book That (Still) Beats the Market by Joel Greenblatt for a basic understanding of what investments are and how to get a simple mastery of them. But in general, investments are simply buying parts of companies (or other things) with the idea that the value of your shares will go up over time. This generally happens faster than inflation and savings rates, so if you have some extra money, putting them into investments is a good idea.
I’m not an investing guru, so I’ll just share some of the things I do, with the caution that you should always do your own research.
Here’s what I do:
- First, maximize your retirement investing. This includes 401k and Roth IRAs and SEPs and other similar retirement investment vehicles. It’s investments designed to be used when you retire, but the importance of these is that they are not taxed right now. So if you earn $70K, and put $20K into a 401k or Roth IRA, you are only taxed on $50K of income. That’s huge, because the money that would have been taxed on the $20K you invested can instead be invested in something and grow over time. It’s a major advantage, and you should maximize this. So if you work at a company with a 401k-type plan, put as much as you can into it. Especially if the company has matching contributions! As a solo business owner, I’ve created an SEP for myself and put as much as I’m allowed into this account each year. This reduces my taxes and maximizes my earnings.
- Next, invest in a low-fee index fund. Basically, research has shown that even the best investors rarely beat index funds (especially when you account for the fees that the investors take out). What are index funds? Instead of an expert human picking your stocks and other investments for you, an index fund just invests based on certain criteria (for example, invests equally in all the companies in the S&P 500 index). This means you won’t necessarily beat the market, but the market does very well over the long term. Remember, this is a long-term game, so you have to leave you money in, instead of taking it out when the stock market drops (horrible idea). There are a number of good index funds — you’ll need to do your own research here, but it’s hard to go wrong. Read more.
- Make your investing automatic. Yes, this is the same advice as in the savings section. Don’t rely on your whims to grow your wealth — set it up and forget about it, reviewing every 6 months or so to see if you can increase the automatic amount.
That’s about it. If you can do these steps, you’ll be very well off. Of course, a qualified investment or financial planner can do better than this advice, but it’s a good route for getting started.