Reviewed September 2003
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Investment Basics: Getting Started Saving and InvestingMost, if not all, individuals and families have some financial goals. However, setting aside enough money for savings and investments to accomplish these goals, as well as choosing the appropriate financial products, can be difficult. Making a firm commitment to saving and investing is probably the most important step in achieving these goals.
Here are some ideas for setting aside funds to save and invest. Some may involve relatively small amounts of money, but, in combination with other techniques, the total can be substantial.
You may think of saving as a form of investing -- and with deregulation of financial markets, there has been some "blurring" of the lines between financial products traditionally considered for investment purposes and those more feasible for savings. However, there are differences between saving and investing.
Savings provide funds for emergencies and for making specific purchases in the relatively near future (generally within two years). The primary goal is to store funds and keep them safe. This is why savings are generally placed in interest-bearing accounts that are safe (such as those insured or guaranteed by the federal government). These accounts are usually also liquid, that is, easily changed into cash on short notice with minimal or no loss. However, these generally have low yields. Because of the opportunities for earning a higher return with a relatively small pool of funds, some financial experts suggest that savers consider slightly higher-risk (but liquid) alternatives for at least part of their savings.
The goal of investing is generally to increase net worth and work toward long-term goals. Investing involves risk. For example, earnings generally are not guaranteed and you could lose some of your original investment (principal).
Before you invest, consider getting your general financial situation under control first, such as by having:
An emergency fund
Financial experts tend to agree that everyone needs an emergency
fund equal to three- to six-months of living expenses. The exact amount needed
depends on such factors as the stability of your income; family size; the amount
of your basic expenses; whether you are covered by unemployment compensation
or other income loss plans; disability and other insurance benefits available
to you in an emergency; other savings and investments that could be accessed;
and the employment or earning skills of other family members.
Why do you need an emergency fund before you start to invest? Households that fail to maintain an adequate emergency fund are financially vulnerable to unexpected occurrences.
An emergency fund can help meet these unexpected financial needs and, at the same time, prevent having to sell or liquidate investments to cover the emergency. Further, it may not be the best time to liquidate these investments or you may have to pay a penalty to get your funds in a hurry.
Savings for short-term goals
Funds often need to be set aside for irregular expenses (those that
do not occur every month, such as real estate and personal property taxes,
insurance premiums, and back-to-school clothing) and to meet other specific
short-term goals (such as for a new refrigerator or a vacation). These expenses
and goals usually do not extend beyond one or two years, so, like an emergency
fund, safety and liquidity are of primary concern.
Unlike short-term goals, intermediate- and long-term goals involve a longer period of time, ranging from a few years to many years. Because of this, you can commit your funds for a longer time and consider a range of investment alternatives. While you may risk not having your money available immediately, you gain the opportunity for greater earnings and protection from inflation.
Adequate insurance
Having adequate insurance for your family is also important. This
generally includes health insurance (with major medical and catastrophic coverage),
life insurance as protection for dependents, disability income insurance for
major income earners, and property and liability insurance (homeowner's or
renter's insurance, automobile insurance, and business insurance where appropriate).
Control over credit
A general rule of thumb for most families is not to commit more than
16 to 20 percent of spendable income to consumer credit obligations (excluding
mortgage payments). Less is better, because you avoid paying finance charges
at high rates. Families with higher percentages of debt should consider increasing
credit payments to reduce debt before taking risks with their money, especially
if consumer credit interest rates are high and returns on most investments
are low.
A retirement plan
Providing for a secure retirement (through an employer plan, on your
own, or both) requires careful planning and regular contributions. Before investing,
it's important to have at least begun planning how to fund your retirement
and making contributions toward that plan. Adequate retirement funds -- such
as replacing at least 65 to 75 percent of preretirement income -- will
probably be one of your investment goals, also.
Equity in a home
This prerequisite depends upon your values. If home ownership is
important, some equity in a home is a good idea before starting to invest.
If home ownership is not important, or if a down payment on a home is a goal
that you plan to work toward simultaneously, meeting this requirement may not
be necessary before starting an investment plan.
There are many things to consider when beginning an investment plan. Some are personal, requiring you to carefully evaluate yourself (knowledge, attitudes, skills, goals, and personality) and your financial situation. Others involve using selection criteria to evaluate specific investments (and specific types of investments).
The interplay of these two sets of considerations is crucial to wise investment decision-making. It's also important to note that, while the remainder of this publication addresses investment considerations, similar considerations need to be taken into account when choosing where to put savings dollars.
When beginning an investment plan, careful consideration needs to be given to:
Investment goals
What do you and your family hope to achieve through investments?
Do you want a secure and comfortable retirement, funds for your children's
college educations, or to build an estate? How much money will you need to
reach your goals? How long do you have to reach these goals? Because these
goals are long-term, it is important that you make them specific, realistic,
measurable, and in writing. This may involve working with a variety of financial
advisers. You also need to prioritize these goals, since working toward one
goal can sometimes hinder progress toward another goal.
Gathering a large sum of money may be overwhelming when you think of the amount as a lump sum. However, when you look at the amounts month by month and year by year, they can be both possible and manageable. The chart below may help you determine a monthly target amount to invest in order to reach a goal.
Table 1
Monthly amount needed to reach a goal.
|
Total dollars needed |
Years to achieve goal |
||||
| 3 | 5 | 100 | 155 | 200 | |
|---|---|---|---|---|---|
| 6 percent rate of return (after taxes) | |||||
| $5,000 | $126 | $71 | $30 | $17 | $11 |
| $10,000 | $253 | $143 | $61 | $34 | $22 |
| $15,000 | $379 | $214 | $91 | $51 | $32 |
| $20,000 | $506 | $285 | $121 | $68 | $43 |
| $30,000 | $759 | $428 | $182 | $103 | $65 |
| 9 percent rate of return (after taxes) | |||||
| $5,000 | $121 | $66 | $26 | $13 | $7 |
| $10,000 | $241 | $132 | $51 | $26 | $15 |
| $15,000 | $362 | $197 | $77 | $39 | $22 |
| $20,000 | $482 | $263 | $103 | $52 | $30 |
| $30,000 | $724 | $395 | $154 | $79 | $45 |
Time available for working with investments
Different investments take different amounts of time to study, evaluate, and
manage. How much time are you willing to devote to researching, studying,
and monitoring your current (as well as potential) investments?
Knowledge of investment alternatives
This consideration is tied to the "time available" one above. Investment
advisers recommend investing in what you know about or are willing to learn
about. If you don't have that knowledge already, are you willing to invest
the time to learn about and evaluate investment alternatives? Even if you work
with an investment adviser, you will need a certain amount of knowledge about
investments in order to ask the right questions and, perhaps even more important,
understand the answers and the consequences of the decisions.
Amount to invest
Realistically, how much money do you have to invest? Is money available from
a one-time occurrence (such as an inheritance), or do you expect to have a
certain continuing amount from current cash flow? Do you have (or can you
acquire) the ability to consistently and regularly contribute to an investment
plan? Recommendations for regular contributions to savings and investments
vary from 5 to 20 percent or more of your take-home income, depending on your
financial situation, your family size, and the number of years until you retire.
Amount to lose
What amount, if any, can you afford to lose? Be realistic. The amount of loss
you can accept will influence the types of and specific investments you choose.
For example, if that figure is nothing or next to nothing, you probably should
not even consider investments, but rather stick to savings. Because of relatively
low yields on savings products, however, inflation will create some loss of
purchasing power.
Present financial situation
What is your present financial situation? What is your income? What do you
own (assets)? What do you owe (liabilities)? Do your assets match your investment
goals?
There are some financial factors also relating to risk. In general, the larger your investment portfolio, the more financially secure you are, the farther off your retirement, and the more optimistic about the economy you are, the more risk you may comfortably assume. But your situation may involve conflicting risk factors. For example, as you near retirement, you probably have a larger investment portfolio (i.e., can assume more risk), but you have fewer years of future earnings coupled with fewer years before retirement income is needed (i.e., can assume less risk).
Risk tolerance
How comfortable are you with risk? We all have different temperaments
and tolerance levels when it comes to risk. If an investment causes you to
lose sleep or not eat, it is a good indication that the investment has a higher
risk level than your personal "risk-comfort zone."
If you are married, what is your spouse's risk tolerance? If it is not similar to yours, some very important discussions and decisions need to occur before investing, such as how to allocate investment funds among alternatives. It may even be necessary to split investment dollars into "his" and "hers," with each spouse investing according to their individual "risk-comfort zone."
Another element involved with risk tolerance is the emotional attachment you feel for a particular investment. Financial experts generally caution people not to become emotionally involved with investments -- to keep them on a business basis. Emotional attachment may prevent you from being objective. For this reason, your home is probably better seen as "housing," rather than a true investment.
These questions may help you analyze your "risk-comfort zone."
The more "yes" answers, the more of a risk taker you probably are. However, only you can decide your tolerance for risk.
Commonly accepted criteria for evaluating types of investments, as well as specific investments, include:
Risk
Risk refers to the uncertainty that the actual rate of return on
an investment will differ from what is expected. It may actually involve loss
of part or all of your principal, so that the rate of return is negative. There
are many sources of risk to the investor. They can act together or separately
and can impact your investments' principal, growth, and income. (See the discussion
on "Sources of Risk" below.)
Some risks are associated with the securities market and the economy as a whole. Generally, these risks cannot be reduced by individual investor decisions.
Other risks are related to characteristics of specific investments, companies, or industries. Individual investor decisions (such as diversifying investments) may help reduce this type of risk.
Return
The gain or profit you receive from investing is referred to as the
return. This may include the receipt of income (interest, dividends, or rent)
or capital gains (where the investment has increased or appreciated in value).
The combination of income and capital gains is the total return from an investment.
Obviously, if the value of the investment has fallen, a negative rate of return may result (depending upon whether income received from the investment exceeds the loss in value). However, if an investor doesn't actually sell or liquidate the investment (but rather holds it) and the value of the investment goes up later, the loss may only be a temporary "paper" one.
Most investors measure return on a yield or rate of return basis -- that is, as a percentage of the amount invested on an annualized basis -- rather than in dollars. That way, you can compare the yields on different investments and find out how much you earned per dollar invested. Remember that the rate of inflation and your tax bracket reduce your net real rate of return on any investment.
Liquidity and marketability
Liquidity is the ability to turn an investment into cash without
significant loss when you need it. Savings accounts and money market accounts
are among the most liquid places to keep funds. Real estate and collectibles
(such as coins, antiques, and art) are among the least liquid because of the
likelihood of taking a loss should they have to be sold to obtain quick cash.
Liquidity is important when there is an emergency and money is needed right away. Overall, collective liquidity is important to the management of a general investment portfolio. Liquidity allows you to change your strategy as the investment climate changes. For example, when interest rates were at historic highs, some investors were able to move long-term investments into those earning the higher rates of return.
Marketability, on the other hand, is the ability to find a buyer when you want to sell, regardless of the potential gain or loss involved. For example, homeowners may discover that their homes do not sell as quickly as they would like (i.e., are less marketable than desired).
Cost
Costs include the price of the particular security, as well as any
fees for purchasing or selling the investment, maintenance, or other services.
Further, there may be a required minimum to invest in a particular security.
Diversification
Diversification is a technique for managing risk. In the simplest terms, it
means that not all of your funds are placed in any one type of investment.
When purchasing stocks, diversification may mean that you own stock in several
companies within an industry or stock in companies that represent several
different industries.
Similarly, when buying bonds, it may mean you have bonds from different companies within an industry or bonds from companies that represent different industries. Bonds or certificates of deposit (CDs) may also have staggered maturities.
As a result, if one investment fails to meet your expectations (or if interest rates, the economy, or other investment conditions change), the impact on overall returns may be less severe. It might be easier for you to remember diversification in terms of a simple rule: Do not put all of your eggs in one basket!
Taxes
Your personal tax status is related to your marginal tax bracket.
When your marginal tax rate is high, you send more tax dollars to the government.
This lowers the amount you have to save, spend, or invest, as well as the amount
you earn from savings and investments.
Of course, there are some investments where contributions are tax-deferred, where interest earned is tax-free, or where taxes on earnings or capital gains can be deferred until some point in the future.
Effort and expertise
This is a factor that cannot be overlooked. Certain types of investments
require little or no time commitment or special knowledge. Others may require
constant management and a great deal of specialized expertise.
Consider carefully the amount of effort and expertise necessary for a particular investment, in light of the personal considerations mentioned earlier. Further, the amount of effort and expertise necessary may determine whether, and to what extent, you rely on an investment adviser.
For example, if you have the time, energy, ability, and interest in studying, researching, and monitoring investments, you may want to consider stocks and bonds. If you lack this time, energy, ability, and interest, you may want to consider investments such as mutual funds, and leave the specific investment decisions to the fund managers.
You can estimate the minimum rate of return (RR) you need to break even with inflation and federal taxes.
Divide the inflation rate by 100 minus your marginal tax bracket (the tax rate you would pay on the next dollar of income earned). For example, imagine that the inflation rate is 4 percent and you are in the 15 percent marginal tax bracket.
RR = 4/(100 - 15) = .047 or 4.7 percent
The minimum rate of return needed to break even is 4.7 percent. In the 28 percent bracket, the rate needed with a 4 percent inflation rate is 5.6 percent.
This guide is designed to familiarize you with the differences between saving and investing and to introduce you to investment considerations -- both personal considerations and investment criteria. The Investment Basics series has this introductory publication, four publications addressing some of the common saving and investment alternatives for the beginning investor, and a sixth publication focusing on selection of an investment adviser.
The Investment Basics series is not intended to provide a complete and in-depth text on investments. Rather, it is designed to provide an introduction to common savings and investment alternatives and to help the beginning investor start to design and implement an investment plan. Investment alternatives more suited to a discussion on retirement planning or insurance, those which require greater expertise on the part of the investor, and those which generally involve a higher degree of risk are also not included in the series.
Information in this publication is based on the laws in force and information available on the date of publication.
There is a trade-off between risk and return. The risk of an investment is related to its expected return. In general, if you want higher returns, you must be willing to accept greater risk. This relationship may not hold exactly true over short periods of time, but over a long investment period, increased return means increased risk.
While there are no hard and fast distinctions (since a particular investment may be more or less risky than others of a similar type, depending upon the specific characteristics of the individual investment), the illustration below may provide an overall guide to types of savings and investments and their relative risk and return.
Note
Within each group, the savings and investments are listed alphabetically.
Sources of risk for the investor include market risk, interest rate risk, reinvestment risk, purchasing power risk, exchange rate risk, business risk, default risk, and financial risk.
Note
Information in this publication is based on the laws in force and information
available on the date of publication
GH33520, reviewed September 2003