There is a clear disconnection between the financial goals we set and the steps most of us take to achieve them. Most of us learn from our parents that saving is the direct (and easiest) path to building up capital and financial freedom.
However, this is now a myth. While saving is key for achieving both goals, making smart investments with your money is what makes them much more attainable in the world.
The fear that stops most of us from investing is a reasonable one, the process of investment is complicated and time-consuming. Many people face financial loss instead of financial gain, particularly in stock and commodity investments.
When we work hard and discipline our lives to leave off spending and save, the thought of losing our hard-earned money makes us uncomfortable. As a result, most of us place our precious money away in a fixed deposit or saving certificate.
This is where the problem arises, the money we place into our safe and sure accounts is almost certain to lose value. The low-interest rates that these options offer are not even linked with inflation. This means that our money’s purchasing power falls as long as we are placing it there only.
Why you HAVE to invest
Saving and investing are two sides of the same coin. While looking to build wealth, saving is a key part of the financial process. BUT saving is important not because it produces wealth on its own, but because it creates the capital needed for investment.
At the least, investing allows you to keep your savings on track with the cost-of-living increases that inflation causes. At the most, the main benefit of investment is the option of compounding interest or growth earned on growth.
How much to save
Given that we all enter the investor market because of unique needs, the best answer to how much to save is ‘as much as you can’. A baseline is to save 20%. As a guideline, saving 20% of your income is the lowest point to start from. In savings, more is always better, but the 20% baseline lets people build up a meaningful amount of capital throughout their work life.
The first step is to use these savings to set up an emergency fund to meet at least three to six months’ worth of living expenses. Once these emergency savings are set up, invest the funds that are not needed for specific short-term expenses. Once you make this a habit, and invested well, this will multiply your capital and help it multiply over the inflation rate.
How investments work
To invest in any form of assets, like stocks, bonds, or other assets, you need to open an investment account. For stocks, this can be with a broker, through a brokerage account. Most people place their investment funds in their brokerage accounts and then use them to fund their trading accounts.
Stocks are small units of ownership in a company. When a company goes from private to public, its stock is open for public trading in the stock market. A stock price is generally reflective of the value of the company, but the actual price is determined by what market participants are willing to pay or accept on any given day.
Stocks are seen as riskier investments than bonds because of their price volatility. If bad news floats about a company, people will want to pay less to buy shares, which will lower the stock price. If you bought the stock for a higher price, and the price falls, you risk losing that money.
In stocks, you make or lose money based on the purchase and sale price of what you buy. If you buy a stock at Rs. 10 and sell it at Rs. 15, you make Rs. 5. If you buy at Rs. 15 and sell at Rs.10, you lose Rs.5.
Gains and losses are only booked or counted when you sell the asset, so the stock you bought at Rs.10 could drop to Rs.6 one day, but you only “lose” the Rs.4 if you sell the stock at Rs.6. At times, if you wait out the low-price period, and then sell the stock when it’s up to Rs. 12, you end up gaining Rs.2 per share.
How to Invest Reasonably?
Once you know how investing works, it’s time to think about where you want to put your money. In general, younger investors with years before retirement can afford to have riskier portfolios.
A long time frame gives investors more years to face the fluctuations of the market and during their work life, investors are usually adding to their investment accounts and not taking money out.
If you have started investing late, and are near retirement, you are more exposed to the volatility of the market. This means that you opt for lower risk and volatility options like bonds and fixed return options.
A higher-risk portfolio would ideally have a higher proportion of stocks and fewer (if any) bonds. As young investors grow older and need to reduce their risk profile, the investment in stocks should decline and investment in bonds rise.
One of the most important steps to take is to make saving automatic. Have your bank automatically transfer a portion of your paycheck into an account specifically for saving. This guarantees that you save constantly instead of making an active choice to set money aside.
This saving should stay in a low-risk option like a bank account and should remain in cash form. This means that you have access to cash for emergencies whenever you need it.
How to Build Up a Portfolio of Investments
The first step is to decide what percentage of your funds you want to place in riskier options like stocks and what percentage you want in safer assets like cash and bonds. This distribution will depend on your risk tolerance. Somebody young and working should invest in stocks entirely, while somebody near retirement age should have a larger allocation to bonds.
The primary purpose of investing is to grow your savings. Investors can achieve this growth through investments in stocks, bonds, and other less common options. Experts invest in commodities like oil, gold, and even crops and can earn huge gains.
In any investment form, you should make it your goal to have a diverse spread of investments. In case you are just starting on your portfolio building journey, you have to make sure that you include options that include both stocks and bonds. Doing this will allow your portfolio to cover both high and low-risk investments.
For someone just starting to invest, take a look at mutual funds or ETFs (both are a collection of stocks, bonds, and other investment vehicles) instead of individual stocks. ETFs and mutual funds are safer options for building a diversified account.
Diversification (which means owning a set of different assets) is important because it reduces the risk of loss. Diversification means that there is a lower risk that your whole portfolio will lose value in a market decline. You will have to look for funds with solid track records and reasonable fees; plenty of popular press and dedicated research sites l will provide this information.
Depending on your financial strength and risk tolerance, you can consider investing in precious metals, commodities, and real estate, all of which are available for investment in the market. All these investments can be effective means to achieve portfolio diversification and manage risk.
A well-constructed portfolio should cover different types of assets (like stocks, bonds, etc.) that do not move in tandem. This reduces the volatility (and risk) of a portfolio without necessarily lowering its return (income) potential.
Save vs. Invest Checklist
The checklist below will help you understand if you need to save or are ready to invest:
- Do you have a cash cushion that can cover three to six months of living expenses? If not, then start saving.
- Do you have other short-term goals requiring quick access to cash (like travel plans)? If so, start saving.
- Are you on track toward reaching your retirement goal by your desired age? If not, start investing.
- Do you understand the risks involved in investing money for a long-term goal like retirement? You may not be able to access it until age 60 without taxes and a penalty. If so, you may want to start investing.
- Do you feel comfortable with your current split of saving and investing every month? Where does it feel like you’re falling short?
Is It Better to Save Money or to Invest?
The answer to this depends on your risk tolerance, financial requirements, and when you need to access your money. Investing has the potential to generate much higher returns than savings accounts, but these higher returns come with risk, especially over shorter time frames.
If you are saving up for a short-term goal and will need to withdraw the funds in the near future, you’re probably better off parking the money in a savings account. If your goals are longer-term, you’ll generally find you can obtain more satisfactory results from investing.
Sadia Zaheer holds a Masters in Business Administration from IBA, Karachi. After working in several financial institutions in Client Management, Corporate Lending, Islamic Banking and Product Management she jumped careers to pursue a career in writing.
She is a Finance, Business and HR Development writer with four years of experience. She reads a lot and takes care of her multiple cats to remain calm.