When it comes to your personal finances, it can feel like there’s a lot to figure out when you’re just getting started. But stick with the commitment to take control of your cash for long enough, and you might notice that almost every rule or financial to-do is based on a few simple fundamentals:
Spend less than you make.
Prioritize your savings over your spending (AKA, pay yourself first).
Invest wisely in a way that lines up with your needs and wants.
Simple, right?
But definitely not easy. There are a lot of nuanced questions that come up even after you understand you need to prioritize your savings -- like how much should you save? Things get more complex when you throw investing into the equation, too.
And what about the relationship between saving and investing? These two actions are not the same thing, even though we sometimes use the words interchangeably. (For example, we usually say things like “save in your 401(k),” but that money is invested, not just saved!)
Let’s start with these questions around saving and investing, and define how much you should aim to save… and of the money you put away for your future, how much of that should be invested?
A Guideline for How Much Cash to Keep
When we talk about “savings,” what we usually mean is cash in the bank or in another very safe, very liquid vehicle. That could include savings accounts, CDs, or money that you literally keep in cash somewhere (although, as we’ll see in a second, that’s not the best move to make).
You want to save money for two primary reasons:
1. To have enough cash on hand to cover emergencies, big and small. This could include anything from needing to repair your car to needing to pay your bills for a month or two if you’re in between jobs.
How much cash you need for emergencies and rainy days depends on how much security you want and how much financial responsibility you have. If you face little risk and no one else depends on your income (maybe you’re single and have a very stable job), then you might only need to aim to keep about 3 months’ worth of expenses in cash.
But if you have kids or anyone else you’re responsible for, debts to repay, or your income (or job status) tends to fluctuate frequently, you need more cash in the bank to cover yourself. You might want to aim for something like 6 to 12 months’ worth of expenses saved.
2. To build up enough cash to pay for seriously big expenses that your normal monthly budget can’t handle. Think a round-the-world backpacking trip, for example, or the down payment on a house.
Basically, anything major that costs a lot of money is something you need to save for. We could even include big, future goals like “funding my lifestyle,” “becoming financially independent,” or “retiring at some point (any point) before I die” in this category.
But this is where we see “saving money” start to fail us. It’s these really big, really expensive, long-term goals that prove problematic when it comes to sitting on your cash. Why?
You can thank inflation. Inflation runs at about 2% a year on average, which means over 30 years, any cash you have today will have far less purchasing power than it does right now. (That’s why you can look back at old ads from places selling whole pizzas for 50 cents or something crazy.)
In other words, if you bought something for $15 in 1970, thanks to inflation, that same thing would probably cost you $100 today.
Inflation is why you only want to keep enough cash on hand to:
Cover your monthly bills, expenses, and spending.
Handle emergencies or unexpected expenses (aim to have 3 to 6 months’ worth of expenses saved in your emergency fund; save up to a year’s worth of expenses if you’re extremely risk adverse or your specific situation leaves you more likely to be short needed income throughout the year).
Have on hand to use for goals you want to achieve in the next 1 to 5 years.
What to Do with Your Cash Once You Hit These Markers
If you have enough cash to cover those points above, then any extra or additional cash needs to go to work for you. Any money you intend to set aside for long-term savings (like retirement) absolutely needs to be invested so that inflation doesn’t erode its buying power over time.
Retirement is something that is 20 to 30 years (or more) away for most of us. With that kind of time horizon, anything you want to save for retirement should really be invested.
Historically, the S&P500 (a common benchmark people use when judging market performance, but not representative of the entire global stock market) has returned a little more than 9% over its lifetime of almost 100 years.
That is far more than the average rate of inflation that hovers around 2% to 3%. And that’s exactly why you need to invest, not just save.
You will find it very, very difficult to save enough cash to build up a sufficiently large nest egg to fund your life once you want to retire because inflation will erode the purchasing power of that money as you go. It’s like trying to constantly fill a bucket with water -- but the bucket has a crack where water leaks out over time
If you invest, however, big goals like building enough wealth to fund your lifestyle once you quit working becomes easier. Instead of money eroding away, your money starts working for you. That’s thanks to the power of compounding returns.
The Power of Investing Comes from Compounding Returns
When you invest, you do so hoping to earn a return. Let’s say you put $100 into an investment, and that investment returns 10%. You just earned $10 that you can then add to your initial contribution of $100, giving you $110 total. If you earn another 10%, you earn $11 this time because your initial return is now earning returns.
Now, you can’t go into investing expecting to earn 10% returns all the time, and certainly not every year (but what to expect from the market and understanding risk and reward starts us off on a whole other conversation!).
I use $100 and 10% because these are nice round numbers that are easy to understand -- but you can play around with the concept of compound interest by using Investor.gov’s online calculator. I used this one to get the results for this example of how powerful investing can be:
When I started investing, I was 22 years old. I started by maxing out my Roth IRA every year, which meant I contributed $5,000 per year. (The rules have since changed and you can now contribute $5,500 per year if you’re under the age of 50.)
If I contributed $5,000 per year to my Roth until I was 65 and I assumed I would earn a conservative 5% return, my ending balance would be about $715,538.67. This is approximate, because it doesn’t take sequence of returns into account, but it gives you the right idea of what compound interest can do for you.
If, on the other hand, I saved $5,000 per year over this same time period, my ending balance would be $215,000 in today’s dollars… but adjusted for inflation, that would probably only be worth about $90,595
Big difference from almost three-quarters of a million bucks.
What Percentage of Your Savings Should Be Invested?
So that brings us to an important question. You know you need to save money. You also (I hope) see the importance of investing for big, long-term goals. How much of the cash you have available to save should be invested instead of sitting in cash?
Personally, my husband and I aim to invest 30% of our gross income at a minimum, but always push for more. Last year, as a household, we invested about 45% of our income.
This, admittedly, is extreme -- because we have big goals and want to be financially independent in a reasonable amount of time. Currently, we should get there when I’m in my mid- to late-40s.
You don’t need to be this aggressive with your money, and you don’t necessarily need to push for financial independence. What we tend to recommend for most people in their 30s is to aim to invest 20% of their gross income per year. Invest more if you have massive financial goals -- but at least aim for that 20% as a baseline.
And if you already have a lot of cash sitting around in savings? Some of it might need to go into the market so it’s working harder for you.
Revisit that list above in this article to see how much cash you should keep on hand… and then if you have more than that? Take the extra and invest it.
Kali Roberge is a personal finance writer who contributes to JUGs to explain how freelancers and entrepreneurs can make the most of their money, and writes about mindful living through intentional spending through her email series, LETTERS. You can find her @KaliRoberge
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JustUsGals Boston
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