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Saving and investing are both important, but they serve different purposes. While everyone wants to earn the long-term average returns of the stock market, risk makes investing all your money inappropriate in most cases.
On the other hand, while no one likes losing money, keeping all your money in an FDIC-insured savings account won’t get you very far toward your long-term financial goals, especially in the current low interest rate environment.
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But how do you know when to keep your money in the bank or invest in the stock market? Here’s a quick breakdown of what could tip the scales one way or another.
An emergency fund is the cornerstone of any financial plan. Having a large emergency fund can protect you from many of life’s unexpected financial surprises, from losing your job to major medical or automobile expenses.
An adequate emergency fund can also relieve financial stress in your life because you know that no matter what happens to you, you have funding set aside to protect you from debt. As an emergency fund must remain essential and intact, it is prudent to keep these types of funds in the bank rather than in the stock market.
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Generally speaking, saving for retirement is a long-term goal. Unless you’re quitting in a few years, you can afford to take risks with your retirement savings in an effort to achieve higher long-term gains.
Keeping your retirement money in a savings account is unlikely to help you achieve your goals. On average, investing in the stock market is a much better way to earn enough to fund your retirement.
Simple math can explain the big difference. If you put $500 a month in a high-yield savings account paying an APY of 0.50%, after 30 years you’ll have about $194,000. This may not sound bad; but if you put that money in the stock market instead and earned 10% a year, you’d have over $1.13 million.
Given that you have time to recover from temporary 30-year market declines, the stock market rally is usually worth the risk.
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If you start saving for education when your kids are born, you’ll be almost 20 years before they need that money. In this case, investing in the stock market is a solid strategy.
If you make 10% a year in the stock market, your money will double roughly every seven years. That means your college investment fund could potentially double or even triple before your kids set foot in college.
But, as with planning for retirement, you should slow down as your first day of college approaches. At this point, preserving what you’ve earned is more important than trying to get a few extra percentage points of return.
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Vacation planning is usually a short-term savings goal. Although some planners may plan a few years ahead, vacations are usually planned about a year or less in advance. With such a short time frame, it’s not worth taking the risk of putting your hard-earned savings in the stock market.
If you jump just before a 20% downdraft, you would need to gain 25% just to break even, which is unlikely to happen in less than 12 months. The few extra percentage points you can earn on your vacation savings by choosing the stock market over a high-yield savings account aren’t worth the risk of losing the opportunity to go on that dream vacation.
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Personal risk tolerance
Ultimately, even though the stock market seems like the best option for your investments, you will have to live with volatility. If you simply can’t stand owning investments that can regularly drop 10% or 20% — and sometimes drop 50% or more — you may need to reduce your exposure to the stock market.
If you have a long-term time horizon, you should have at least some exposure to the stock market. But find a balance between investments that can help you reach your financial goals and those that let you sleep at night.
In a nutshell, most market experts recommend a time horizon of at least two to five years if you plan to invest in the stock market. If your financial goal is right in front of you, the risk of you experiencing a significant market decline outweighs the possibility of earning higher returns.
Over a 30-year time horizon, you will have the ability to return after a market sell-off. Over a one-year horizon? Not that much.
But being too conservative can prevent you from achieving your financial goals. As “risky” as the stock market may seem, you may be taking on even more risk by avoiding the market over a long-term horizon.
Although the stock market regularly “corrects” by 10% or more, there has never been a 20-year period in which the S&P 500 lost money. From this perspective, there seems to be more risk in staying out of the market than investing in it for the long term.
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