Posted by by Cindy Wilson.
My earliest money memory is of a porcelain piggy bank, hot pink and loaded with dimes.
When I grew up, I put away childish things, but the piggybank—pigheadedly—stuck around as a concept. It does for a lot of people.
While funneling money into a single savings account each month is a worthy endeavor, it is important not to forget that savings should be broken down according to specific end goals.
In other words: We need to strike a hammer blow to the whole piggybank idea.
Savings accounts are unquestionably a powerful vehicle—with a specialized function: To provide a cash reserve you’ll need immediate access to, in the event of an emergency or a specific short-term goal (like a summer vacation).
For anything with a horizon further than that, you’ll need a different level of investment—one with a fighting chance of keeping up with inflation.
After all, you wouldn’t put your retirement money into a piggy bank. Just like you wouldn’t place emergency funds in a 401(k).
A good start is to define what your goals are—what are you saving for? You can write those goals down under the headings Short-term, Medium-term and Long-term. Then choose the investments or savings vehicles and instruments appropriate to each of those different timeframes.
*Investment products, including bonds and mutual funds, are not FDIC insured or bank guaranteed, and may lose value.
Short-term savings vehicles and instruments
The base of the pyramid is your security and protection. Money for short-term enterprises should be liquid, meaning easy to get to. But if you’ve checked the interest rate on your checking or savings account lately, you’ll know that liquid money earns little interest—typically 0-2%.
Online savings accounts may offer a higher interest rate.
Bricks-and-mortar banks are more expensive to operate than the virtual kind, which don’t need to employ tellers, among other overheads. This cost saving is reflected in the interest rate. The downside of having no physical bank to go to is you can’t get hold of $5,000 in cash, at a moment’s notice, the way you generally can during a weekday at a traditional banking institution. I, for one, have needed to do that on occasion, for buying a horse. At such times, cash is usually preferred over checks (too many of which have bounced, after the buyer literally rode off into the sunset).
Medium-term savings vehicles and instruments
If you’re willing to have your money locked up for the medium term (1-7 years)—let’s say you’re saving up for the down payment on a home—your money will work a little bit harder for you. Certificates of Deposit can be a good option when you’ve got an exact time horizon in mind (a wedding day, a first semester at college) because they mature after a defined number of months or years. I’ve talked a bit before about CDs, and how to put idle money to work on a “CD Ladder”. CDs can be a good way to lock down your money with a higher interest rate, although fixing an interest rate in a low-interest environment can have its downsides. While your money is in a CD, for however long it may be (three months, five years), you sacrifice liquidity.
Long-term savings: Things get riskier towards the top of the pyramid.
At the summit there’s a much wider margin for big gains—and big falls. When choosing a fund, consider fees, expense ratio and past performance (while they can’t guarantee future results, historic returns can at least help to inform you).
Long-term saving beyond the 403(b), 401(k) and IRA
First and foremost, if you have an employer match, understand how much you need to contribute to get the maximum match. Then, if you can afford to contribute more, a good rule of thumb is to always try to save 10% of what you make, for retirement. Then, if you max out in any given year and still have money to invest long-term (from a windfall, say) you can open a brokerage account and invest in mutual funds that way.
Just remember: This pyramid provides a rough illustration; the investments and savings vehicles on it may apply to more than one level. For example, it may be a good idea to diversify a 403(b) portfolio with bonds, even when retirement is decades away.
Money can pass fluidly between different levels of the pyramid: A big believer in diversification, I have seven separate mutual fund accounts, one of them a money market account. I don’t have immediate access to my money market account but it will allow me access if I choose to write a check for $250 or over. I occasionally rebalance my portfolio, shifting money from lower-interest, lower-risk accounts like money market funds, into more volatile funds, like stock mutual funds, which offer greater potential for long-term growth.
Struggling to get a foothold?
This pyramid is all very well, you might say, but what if you’re having trouble just reaching the point where you can save and invest, rather than pay off debt? Plenty of my clients are dealing with debt, and saving doesn’t seem like an option.
When I meet people who are struggling to save anything, we look at their monthly budget together and find a way to live within their means. If sacrifices need to be made, the luxuries in their budget take the hit. (And there are always luxuries!)