At its most basic, making smart financial choices doesn't seem so hard. Save more than you spend, don't spend money you don't have, and stash away some cash for a rainy day. Do all these things, and you should be in good shape to live comfortably in retirement, right? Not necessarily.
No matter how you look at it, retirement is expensive. The average American spends around $46,000 per year during retirement, according to data from the Bureau of Labor Statistics. So if you spend 20 years in retirement, that adds up to $920,000 -- not accounting for adjustments for inflation.
You could easily end up spending more than $1 million during retirement, especially if you live in an expensive city or plan to spend your golden years traveling the world. Healthcare expenses alone can be incredibly costly; the average 65-year-old couple can expect to spend around $280,000 on healthcare costs during retirement, according to a recent study from Fidelity Investments.
If you want to ensure your nest egg is strong enough to handle these kinds of costs, you'll need to do more than just save more than you spend. You'll need to be strategic about how you invest your money.
Why a simple savings account won't cut it
Savings accounts are great, and it's never a bad idea to sock away money somewhere you won't be tempted to spend it. But even high-yield savings accounts' interest rates pale in comparison to the returns that money could earn if you invested it instead. And when you take inflation into account, money left sitting in a savings account will likely lose value over time. Most high-yield savings accounts offer interest rates between 1% and 2%, while the annual U.S. inflation rate typically hovers between 2% and 3%. In the short term, you won't notice much of an impact. But over a few decades, you'll start to notice that your money isn't worth what it used to be.
That's why, if you really want to see your savings grow, you have to invest it. Unfortunately, after the Great Recession, many Americans are nervous about putting their money in the stock market. In fact, only 54% of Americans own stocks, according to a 2017 Gallup poll.
While it's natural to worry about losing your money, it's even riskier not to invest at all. Because if you don't, you could reach retirement age without nearly enough savings to live comfortably.
Saving versus investing: See the difference
Say you're currently putting money in a savings account earning 2% annual interest. That's not bad, and it may not seem worth the risk to invest your money and earn an annual rate of return of, say, 6%. After all, what difference could just 4% per year make? Well, over a few decades, it could amount to hundreds of thousands of dollars.
For example, say right now you have $10,000 in a savings account earning 2% annual interest, and you're contributing $100 per month. If you had instead put that $10,000 in an IRA or 401(k) earning a 6% annual rate of return and continued contributing $100 per month, here's what a difference it would make over time:
|Years||Total Savings When Earning 2% Annually||Total Savings When Earning 6% Annually|
A 4% difference in returns may not sound big, but thanks to the power of compound growth, a small increase in annual returns leads to exponentially greater gains over time.
Despite the strong numbers, though, some people may still be on the fence about how safe the stock market really is. And while it's unrealistic to expect to earn the same return every single year, over several decades, the highs have historically outweighed the lows.
In the midst of the Great Recession, for instance, the Dow Jones Industrial Average hit its lowest point on March 3, 2009, when it reached 6,626 points. By early 2018, though, it hit an all-time high of 26,600. Of course, there will be more bear markets in the future, but the market has always managed to climb to new heights over time.
The best way to protect your money is to think about how much risk you can tolerate when you start investing. If you'd like to avoid as much risk as possible, don't invest your life savings in that new tech company hoping it will turn into the next Amazon. Instead, invest in low-cost index funds. While they're considerably less exciting and may not generate wild returns, they will match the returns of the index they track -- perfect for investing your money and simply letting it grow for a few decades.
If you already have strong financial habits, give yourself a pat on the back, because you're ahead of many people who are preparing for retirement. But simply saving your money isn't enough. You should also be making your money work for you by investing it. Your future self will thank you.