If you’re stashing all of your savings in a checking account, you are actually losing money. Inflation is on track to hit 2% this year and the average yield on an interest-bearing checking account right now is 0.04%.
That means the prices of the things you buy are increasing at a faster rate than your money is growing.
So what should you do with your savings instead?
Here’s the “Savings Pyramid.” Keep in mind that personal finance is not one-size-fits-all. While this serves as a great starting point for figuring out what to do with your savings, everyone’s situation is unique and has factors that can change this order, like an employer retirement match or pressing short-term goals.
Establishing an Emergency Fund is the first thing you should do when you have some extra cash. Park it in a high-yield savings account so you can earn interest and keep adding to it until you feel confident that the balance is high enough for you to handle any financial surprises that life throws your way.
At a minimum, that should be three months’ worth of living expenses but feel free to go higher. Some get peace of mind from being extremely prepared and have chosen to save enough to cover an entire year.
Once Emergency Fund is checked off the list, you can shift your focus to making your money work for you.
If you have high-interest debt, you should pay it off before climbing the “Savings Pyramid” any further, aka starting to invest your money.
That’s because historically, U.S. stocks have delivered an average annualized total return of about 9.8%. That means for every dollar you invest, you’d likely be making a return on investment (ROI) of 9.8% or less over time.
On the flipside, the average interest rate on a credit card is more than 16%. So every dollar you put towards paying off your balance is generating around a 16% return because you no longer have to pay that interest to your card issuer. That’s a much higher return than what you’d get from investing.
Now that your Emergency Fund is fully stocked and you’ve eliminated high-interest debt, you’ve earned the right to start investing.
The first step is to focus on retirement. If you want to maintain your standard of living in your golden years, you should be saving at least 10% of your salary in a retirement account like a 401(k) or IRA. These account types come along with tax advantages that will help you get more bang for your buck.
While saving for retirement doesn’t sound like the most exciting thing to do with your money, especially when you’re young and retirement is decades away, it’s extremely important. Think of it as making sure the “future you” is well taken care of and living comfortably.
You probably have a lot of big goals between now and retirement that will take years to achieve, like buying a home or starting a business. A taxable investment account is a great place to save for these goals because it allows you to generate returns while you continue to save up.
A major difference between a taxable investment account and a retirement account is accessibility. With retirement accounts, it’s generally difficult to access that money without consequences before you reach retirement age.
With a taxable investment account, you can liquidate your investments and use them for whatever you want, whenever you want.
If you still have money left over after taking care of all of the previously mentioned items, then you can gamble with speculative investments—if it’s something you’re interested in doing.
Speculative investments are high risk/high reward; you either win big or lose big. Some examples include investing in a friend’s startup, buying cryptocurrency, and day-trading options.
Yes, you could make a fortune and your friend’s startup could be the next Facebook. But it could also fail and your shares could become completely worthless. So before you make a speculative investment you need to be completely comfortable with the possibility that your investment may go all the way down to $0.