Last we week talked about savings. We discussed how many people aren’t prioritizing savings as much as they should, largely because life events come up. You can fix this by making a plan for what you want to do with your savings. Everyone has several goals in mind, putting pen to paper and committing these goals is key. Today I want to talk about another problem that affects savers and spenders alike: not making your money work for you.
Many people I talk to have some savings and they are interested in planning and finding other avenues to save — but a lot of them haven’t really learned about how to make their money work for them. What do I mean by that?
For starters a lot of young professionals keep too much of their retirement funds in cash, “cash reserves,” or some type of money market fund. They do this because “cash reserves” sounds safe and they would characterize themselves as being conservative investors. Sometimes this problem affects savers outside of their retirement too. They build up too much money in their savings or checking account and don’t have a goal for it. Meanwhile, it sits earning little to no interest. Perhaps they are nervous after losing money during the financial crisis, perhaps they are perfectionists and don’t want to do any real investing until they find the time to fully understand their options. Whatever the reason, if you’re doing this, it’s holding back your finances.
Why? Because of inflation. Although inflation has been historically low the past few years, on average, it’s about 3% per year. When you don’t earn at least the rate of inflation on your “cash reserves” your nest egg actually loses value rather than gains over time.
Last week I talked about how $1,000 saved in your 20s will be worth over $20,000 at retirement. That sounds great, right!? But guess what, when you adjust that value for inflation, that $20,000 will give you the equivalent spending power of $6,000 in today’s dollars. If you had kept your funds in cash savings earning next to nothing in interest, you’d only have about $1,040 at retirement. Now you see why making your money “work for you” is really important. Inflation will eat your lunch if you don’t adjust for it.
Interest, capital gains, and dividends are all different ways having your money invested works behind the scenes without you having to do a thing. Markets do go up and down and it may be scary when markets take a dip from time to time, but you’re still earning dividends and interest along the way. The overall trajectory of the markets is positive, and your invested money is expected to out earn inflation in the long run.
The Solution
If you have a lot of money sitting in cash (outside of your necessary emergency fund), give every one of those dollars a job earning you more in interest and dividends. Find a good mix of stock and bonds to invest in. You want to invest broadly in the market, not in 3-4 stocks at a time. If you’re heavily invested in cash or cash equivalents now is a great time to rebalance into something that makes sense for you. When in doubt, low cost Vanguard index funds are a good way to go.
An easy solution for retirement offered by many employer-sponsored retirement plans are target date funds. Pick a target date for retirement and invest in that fund. These funds will give you an asset allocation that is part stocks and part bonds. Without you having to do anything, over time the asset allocation will become more conservative to include more and more bonds and prepare you for set income needs in retirement.
Pay attention to the fees and expense ratios that your retirement or brokerage charges too.
Aside from investing in stocks and bonds, which are mostly passive strategies, there are other ways to make your money work for you. Do you have fixed assets like a home that aren’t used 100% of the year? Can they be rented out? What about a business idea or something you can do on the side to earn extra income? There are lots of diverse ways to make your time and your dollars work for you. Spend some time thinking about this. Use your money for wealth creation rather than getting by today.
Hopefully the second edition of the “problem areas” series helped you understand that sitting in cash, especially with your retirement funds isn’t “safe” and actually creates negative purchasing power. Making your money work for you not only prevents this, but grows your wealth over time too. Stay tuned next week for Problem Area #3 – being reactive rather than proactive with your finances. Included in this will be a discussion about the importance of financial goal setting.
This is the second article in a three-part series about how to avoid common financial problems. You can click these links to read Part 1 and Part 3.
