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We’ve been getting lots of questions lately about different saving and investment accounts. There are just so many to choose from!
We love that there are great resources available for learning about each account type (thanks Investopedia!), but my goodness that amount of info is overwhelming. Wouldn’t it be awesome to have a one-post overview of these investments? And to not wade through a bunch of jargon to see which investments are right for you?
Here’s a big-picture overview of the most common saving and investment accounts for you. With descriptions in plain English and a little blurb about who benefits most from each type.
Bank accounts are the most basic level of saving and investing. Everyone should start their financial journey with a checking account and a savings account. Then you might want to consider CD’s and Money Market Accounts for some savings goals.
Checking accounts are just money hubs. Your income is delivered to your checking account by your employer or clients, then it exits to savings, investments, and expenses. So your checking account is a temporary pass-thru point for your money. You don’t want to store any money in your checking account because it’s not earning any interest sitting there. And you’re more likely to spend it on crap you don’t need because it’s super easy to access.
You’re probably familiar with savings accounts. They’re the safest place to keep your money because they’re insured by the Federal Government (up to $250,000, which is fine because you shouldn’t have anywhere near that amount kept in a savings account anyway). Unlike your checking account, money in your savings account earns a little (very little!) interest.
A basic savings account is the perfect place to keep your emergency savings fund. It’s separate from your checking account, so you’re less likely to spend it on junk. But it’s completely liquid (financial speak for accessible), so the money is always available as soon as you need it.
Word to the wise: you don’t want to keep too much money in savings, because you can get better interest earnings by investing your money elsewhere. Savings accounts are for emergency funds only!
CD’s (Certificates of Deposit) are “time deposits”. You deposit your money with the bank for a certain amount of time, at an agreed-upon interest rate. So at the end of that time, the bank gives you your money back plus your interest. For example, you can get a $500 5-year CD, earning 2.3% interest. At the end of the 5 years, you get your $500 back plus about $60 in interest.
Generally, the more money you invest and the longer the holding period, the better the interest rate.
CD’s can be a good option for some of your dream savings (you know, the savings you keep for a specific dream like travel, buying a house, or starting a business). The money is very safe; most are insured by the Federal Government, so you’re promised your money back plus your interest. And it’s relatively inaccessible, which is also good because then you can’t spend the money on something else while you’re waiting. CD’s are our investment-of-choice for dreams that are expected to be 3-7 years down the road.
Money Market Accounts
Money market accounts sound fancy, but they’re really just slightly more sophisticated savings accounts. They’re still FDIC insured, so your money’s safe. But they usually require higher minimum balances than savings accounts (like you have to keep at least $x in the account at all times), and they give you better interest rates in return. Typically, the higher the minimum balance, the better the interest rate.
Money market accounts are perfect for your short-term dream savings. If you plan to make your dream happen within the next 3 years, money market accounts will keep your money safe and slowly growing until you need it.
Stocks, Bonds, and Investment Funds
Now that we’ve covered the basic bank accounts, we can graduate to the more fun stocks, bonds, and funds.
Unlike the safe-as-can-be bank accounts, there’s some risk involved in these investments, but that also means greater potential rewards. This is where you have the opportunity to really put your money to work for you!
Stocks are ownership shares of a company. So when you buy Apple stock, for example, you own a small piece of Apple (a very small piece! Like 1/5,213,840,000 of the company).
If the company does well, your stock gets more valuable because more people want a piece of the company. So you might be able to buy a stock for $30, then sell it 6 months later for $35. Doesn’t sound like much, but what if you spend $3,000 to buy 100 shares? If you could sell for $35/each, you’d make $500!
You also might receive dividends, which are payments some companies make to their shareholders (fancy word for stock owners). You can reinvest those dividends to buy more of the company’s stock to help the value of your portfolio grow faster.
The problem with stocks: there are no “safe” stocks. If the company starts sucking, the stock price could go down, and you could lose money. Chipotle is a perfect example. Everything looked great for them in 2015. Their stock price was way up to $749. Then E. coli hit, and boom, their stock plummeted. Over the next year, their stock dropped to $370. Investors lost as much as $379 per share! And no amount of financial analysis could have predicted it.
Buying an individual company’s stock is a risky game, and I don’t play it. And neither should you. There are better options.
Bonds are like little loans investors make to organizations (often federal agencies or branches of the government). Almost like CD’s, you agree to let the organization use your money for a certain amount of time, and when that time is up, you get your investment back plus the agreed upon interest.
So bonds are much safer than stocks. But that also means the potential reward is lower.
Bonds are a good option for older investors who are more interested in protecting their money than growing it. As a young investor, you can take more risk with your investments (and hopefully reap better rewards!) because you have time to recover from the periodic market dips. But older investors are retired and living on the money their investments produce, so they can’t afford to take much of a hit.
Ok, now we’re getting to the gold. Welcome to investment funds! These are the better options we’ve been leading to.
Investment funds are like sampler sets of a bunch of different stocks or bonds. When you buy a share of an investment fund, you’re automatically investing in a bunch of different companies or organizations instead of putting all your eggs in one basket. This is what investors mean when they talk about “diversifying your portfolio”. Investment funds = automatic diversification!
Don’t invest in individual stocks or bonds. Invest in funds! Let’s look at a couple investment fund options.
Mutual Funds and Index Funds
Standard mutual funds are “actively managed” investment funds. This means a portfolio manager is actively involved in adjusting the funds to try to make them perform better than average market return rates. There is a fee for this management service. The fees averaged 0.84% of the account’s balance in 2015 (source). These fees are automatically deducted from the returns generated by your account, so you don’t have to budget for the expense to come out of your pocket.
Until earlier this week, I loved Mutual Funds. They made me feel safer: everything’s ok, there’s a highly-paid analyst reviewing and managing my funds, so they will get me the best possible returns. Except, turns out, those highly-paid analysts are often wrong. For example, they couldn’t have predicted Chipotle’s implosion.
Freakonomics just aired a fascinating podcast episode about how wrong mutual fund managers are, and how much money investors are wasting on their services. Totally eye-opening! We’ll be diving into the details in next week’s happy hour. But here’s what you need to know for now: there is a special type of mutual funds called index funds, and they’re your better bet.
Index funds passively follow the market as a whole. For example, you could invest in an index fund that follows the S&P 500. This fund would include a portion of stock from every company on the S&P 500.
Index funds just keep pace with the market; they don’t try to outperform it. The crazy thing is, over the long-term, these passive funds usually perform better than the actively managed funds. And when you consider the difference in fees (a very low .11% average for index funds), you’re very-nearly always better off in the end with index funds.
Of course there’s some risk with any investment fund. The cool thing is, you can control some of the risk by investing in different index funds. Some are only made up of bonds, so they’re safer than those made up of stocks. You can invest in a couple different index funds, some of just bonds and some of just stocks to diversify your portfolio further.
We like bond index funds for medium-term dream savings (dreams you want to realize in the next 3-7 years), and stock index funds are our #1 recommendation for long-term investing.
ETF’s (Exchange Traded Funds)
ETF’s are a lot like mutual funds, but they can be bought and sold on the stock market at any time during the trading day. This is great for people trying to time the market to the minute, buying at the exact moment they think the stock price is lowest, and selling at the exact moment they think it’s highest.
The flexibility of being able to buy and sell at the drop of a hat is cool, so I’ve got a small portion of my long-term dream savings in ETF’s, and the rest in stock index funds.
There are many different types of retirement accounts, but most people go with a 401(k), an IRA, or a Roth IRA. We’ll give you a brief description of each, but you can get all the details in our 3 Easy Steps to the Retirement of Your Dreams.
And yes, you need to have a retirement account. Yes, even if you’re only 21. Thanks to compound interest, the interest earned on your account grows exponentially the longer it’s in your account, so the sooner you can start the better. Check out The $831,751 Reason to Save for Retirement While You’re Young and Broke.
401(k)’s are employer-sponsored retirement accounts. They have the best perks of any retirement plan, so if your employer offers a 401(k), take it!
Your employer will automatically deposit your contribution in your 401(k) before issuing your paycheck. So you’ll never forget to transfer the money to your account or accidentally spend the money you meant to save for retirement. And your contributions are pre-tax, so you won’t pay income tax on the amount you contribute.
You’re legally allowed to save more in a 401(k) than in IRA’s or Roth IRA’s, so you can set yourself up for greater financial success. 401(k) contribution limits are currently $18,000/year, while IRA and Roth IRAs are just $5,500.
Oh, and you might even get free money with your 401(k)! Many employers offer contribution-matching. Like, they’ll match your contributions to your account up to a certain amount. Just ask HR about the details (like you might have to stay with the company for x years to keep the portion the company contributed).
IRA’s (Individual Retirement Arrangements) are a common alternative to 401(k)’s. They’re also pre-tax accounts, so you’re not charged income tax on the amount you contribute to your IRA.
To replicate the simplicity of automatic 401(k) contributions, you can set up auto-transfers from your checking account to your IRA every pay-day.
The downsides are: you can only save up to $5,500/year, and you can’t get free money from a contribution-matching program.
Roth IRA’s work just like IRA’s, but with one big difference: taxes. Unlike pre-tax IRA’s, Roth IRA’s are post-tax accounts, so you don’t get to deduct the amount of your contributions from your income taxes. But the great thing about this arrangement is that, unlike 401(k)’s and IRA’s, you won’t be charged income tax on this money when you start using it at retirement.
As a general rule, the younger you are, the more you should consider Roth IRA’s instead of traditional IRA’s. You’ll have more time until retirement to take advantage of the magic of compound interest to grow your nest egg, so you can rely less on using pre-tax dollars to pad the account.
Options, Futures, and Annuities
Um…these are more complex. They’re investment options that make some people good money, but they’re more for seasoned investors. Gonna be honest here, we’ve never invested in options, futures, or annuities. They kinda scare us 😉
Let us know in the comments if you’re interested in learning about these, and we’ll get to work figuring out the details for you!
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Which of these saving and investment accounts do you currently have? Are you happy with them?