Sparing any money for retirement savings is a challenge, but that's only half the battle. You also have to decide where you're going to house that money so it can grow over time without exposing you to too much risk. The right choice depends largely on the types of accounts you have access to and your long-term goals.
But there's one place you should never house the bulk of your retirement savings — at least if you hope to retire anytime soon.
How much are you earning on your savings?
Personal retirement savings can be broken down into two parts: your contributions and your earnings.
Contributions are the dollars you earn that you set aside for your retirement every year.
Earnings are the extra money you get from the place you keep your money.
Saving in a savings account: If you house your money in a savings account, your earnings are based on your account balance and your annual percentage yield (APY). The current average savings account APY is 0.06%. That means for every $10,000 you have in your account, you'll earn $6 per year.
Saving by investing: When you're investing, your earnings depend on your investment returns. Investing in bonds could bring earnings of around 5% to 6% per year. Investing in stocks could potentially net you a 30% return in a very good year, but you could also lose just as much in a bad year.
Your returns also aren't guaranteed until you sell your stocks. Prices fluctuate over time. That can have a significant effect on your portfolio balance, especially for those with substantial savings.
This volatility can make investing seem like a risky proposition compared to keeping your money in a savings account where it seems you can only stand to gain, albeit at a slower rate. But that's a false premise.
So what's riskier? Saving for retirement in a savings account, or investing?
For one, money in a savings account is only protected up to $250,000 per person per bank. If you keep more than this in a savings account and your bank goes under, you could lose the extra. While unlikely, it's a risk you probably don't want to take.
Keeping your money in a savings account can also be risky because the rate of inflation often exceeds even the best savings account APYs (annual percentage yield. That means that you'll actually lose buying power over time because the rate your savings are growing at isn't enough to keep up with the rising cost of living.
While investing does carry a risk of loss, there are things you can do to reduce that risk. And the long-term earning potential can make saving enough for retirement a much easier task.
Let's say you're 25, trying to save $1 million by the time you're 65. If you keep that money in a savings account with a 0.06% APY, you'd have to save at least $2,059 every month for 40 years in order to achieve your goal. And even then, you'd be exposing yourself to the risks discussed above.
If you'd invested that money instead and you earned a 7% average annual rate of return, you'd have to save just $405 per month. Over 40 years, that amounts to nearly $794,000 less in personal contributions to reach the same goal. Imagine what you could do with $794,000 over the course of your life. Investing's not looking so risky anymore, is it?
Balancing risk and reward when saving for retirement
The upsides to investing are undeniable, but that doesn't erase the fact that there is risk to investing. If you choose the wrong investments is a risk in itself.
For example, if you get swept up in the meme stock craze — you could end up losing your money when the stock's share price falls to reflect its true value or when the company goes out of business.
If you want to maximize the benefits of investing while minimizing the risks, you have to diversify your investments. That means putting your money in several companies and several sectors. This way, no single company or sector can affect your portfolio too much.
An index fund is a great way for beginners to quickly and affordably diversify their savings. These are bundles of stocks you purchase together, so you instantly get a small piece of each one. Look for an index fund composed of large, established companies that you believe will be around for decades to come. These stocks may not increase in price as rapidly, but they typically generate consistent returns over time.
You should also invest some of your money in bonds, and you should move more of your money into these over time. This will help you avoid some of the volatility of stocks as you get closer to retirement age while still helping you earn a better return than you'd get by leaving your money in a savings account.
Investing will never be risk-free, but in the long run, it's probably less dangerous than keeping your savings out of the stock market altogether. If you're still hesitant, start small and then try to increase your contributions over time as you get more comfortable. Use a retirement account too so you can take advantage of the tax advantages these accounts offer.
And remember, when you're talking about retirement savings, the short-term swings don't matter. Focus on the long term. If you can do this, you might just be surprised by how fast you reach your retirement goal.
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