A Simple Rule for Deciding Whether to Put Money Into Savings or the Stock Market
When you have spare money, what should you do with it?
When you're setting money aside for the future, you'll need to make a decision about what to do with it. There are many different options, but it often makes sense to decide between these two choices: Put the money into a high-yield savings account, or invest it in the stock market.
You'll typically choose from these two options. As long as you make smart investment choices, the stock market can provide reasonable returns without unreasonable risks. On the other hand, high-yield savings accounts are virtually risk free and the returns are similar to other safe investments.
But if you plan to put the bulk of your saved funds into one of these two asset types, you'll still need to decide which one to choose. The good news is, you can follow a simple rule of thumb to make that decision.
Should you put money into savings or invest it in the market?
Most experts advise against investing money in the stock market if you'll need it within the next two to five years. There's a good reason for that. The market tends to offer a consistent 7% to 10% average annual return over time -- but that's average annual returns. In some years, you'll earn much more and in others much less.
A savings account will pay much less interest. However, it's consistent and you won't need to tie up your money -- as you might with a CD or bond. And there's almost zero risk. Especially if the account is FDIC insured.
Let's say you invest money you'll need within a year or two. You could put your cash into the market right before a crash, and recovery might then take longer than you have. The market has always rebounded, but it can take time. If you can't wait out the rebound, you risk having to sell at a loss. But if you give yourself enough time, you can feel pretty safe about taking the chance to invest.
Of course, two to five years is a pretty long time range. So you'll need to decide where on that scale you want to fall. For me, I've chosen a three-year period. That's based on the fact that when the market has historically fallen into a bear market (fallen at least 20% from its high) the average length of recovery is two years. I prefer to err on the side of caution and allow myself a little extra time above this average.
How much risk do you want to take on?
You may decide to choose a different time period. A lot depends on how risk tolerant you are. It makes sense to consider the consequences of selling at a loss. The more damaging a loss would be, the more cautious you should be if you'll need the cash soon.
Of course, there's no perfect rule. The important thing to remember is, the shorter your investment timeline, the greater the risk you'll have to sell at a bad time. But if you definitely won't need the money for at least five years, investing is almost always going to be your best bet. Otherwise, the potential returns you earn in savings may not be enough to keep pace with inflation -- much less to help your money grow at a reasonable rate.
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