Hey everyone, welcome back to Twenty2Cents. Last week we talked about how to save money, which is the first step to building your financial foundation. If you’ve started saving, that’s awesome! You’re on your way to financial freedom. But where should you keep the money you’re saving? We’ll explore the best ways to preserve and grow your money for the long haul below.
Before I begin, I should state that this is not professional financial advice. I am also not your dad. I can’t tell you what to do. What I can do is tell you how I think about where to save my own money and explain some basic financial concepts. My hope is that after reading this post, you’ll feel more comfortable choosing where to put the money that you worked so hard to save.
Choosing Where to Save
To choose where to save your money, you need to keep in mind why you’re saving in the first place. If you haven’t read last week’s post about why and how to start saving money, you can check that out here. If not, I’ll save you some time. The three main reasons we save money are to prepare for the unexpected, purchase big-ticket items in the future, and ultimately, achieve financial freedom. These are very different motivations, and each one is served best by different saving/investing vehicles. To determine the best options for each of these, it’s helpful to think of your savings as three separate entities, each serving their respective purposes.
Before I talk about the best options for each category, it’ll be useful to understand some basic finance terms.
Definitions
- Purchasing Power – The ability to buy products and services, AKA the value of your money. You might think $20 is $20, but that’s not the case. $20 could buy more stuff in 1970 than it can now. This is because of our next term – inflation.
- Inflation – The rate at which prices of goods and services increases over time. The reasons this happens are a little complicated and beyond the scope of today’s post. What you need to know is that generally speaking over the last 100 years money has become worth less over time (In the U.S).
- Asset – Any resource owned and/or controlled by you. Cash is an asset, and so is your intelligence. Financial assets are assets that are worth money.
- Liquidity – How quickly an asset can be converted into cash. Examples of liquid assets are cash and stocks. The opposite of liquid is illiquid, meaning it is harder to turn into cash. An illiquid asset would be something like a house. You can sell it, but it’s a complicated transaction and it takes time.
- Volatility – How much the price of an asset changes over time. Crypto is an example of an extremely volatile asset, while cash is an example of an asset that is not volatile.
- Return – In finance, return refers to how much profit an investment generates. If you invest $100 in a stock, and then sell that stock for $120 later, you would have a 20% return on that investment.
- Time Horizon – In finance, a time horizon is how long you plan to hold an investment. If you are investing in your retirement account that you won’t use until 40 years from now, you have a 40 year time horizon for those investments.
Ok cool, now we’re all on the same page.
The Three Bucket Framework
My preferred method to think about organizing savings is an adaptation of the 3 bucket framework described by Scott Galloway. If you haven’t read his book The Algebra of Wealth, I highly recommend checking it out. It’s full of practical advice on how to build a career and achieve financial success, whatever that means for you. Amazon link here.
In his book, Scott describes the 3 bucket framework for organizing all of his finances. All of his finances go into one of three “buckets” that are categorized by how he plans to spend the money in each particular bucket. I like to apply that same method to just the portion of my money that I consider “savings”. The premise of the 3 buckets is to have 3 separate “buckets” of money, each serving a different purpose. For savings, the 3 buckets are an emergency fund bucket, intermediate bucket, and long-term bucket.
Bucket 1: Emergency Fund
This is a short term-bucket for emergencies and unexpected expenses. Surprise car repairs, an unexpected layoff, or a visit to the hospital are all examples of events that this bucket is intended to cover. You likely won’t have all three happen at once, so you only need enough in this bucket to cover your costs for one major event or a few months expenses. A good rule of thumb is somewhere between 2-6 months of expenses. The more financial obligations you have, the further to the right you will want to be in that range. If you’re young, still live at home, and your parents don’t force you to pay for anything, you can probably get away with even less in this bucket.
Where to Save Your Emergency Fund
Since this fund is for emergencies and unexpected expenses, this bucket of money should be highly liquid. The best option for most people will be a high yield savings account. It’s just like a normal savings account except it has an elevated interest rate relative to normal bank accounts. The elevated interest rate allows your money to grow while it’s stored and also protects your purchasing power against inflation. Interest rates change all the time, but current high yield savings accounts offer yields around 3.7% (per year). That’s not bad for having your money sit someplace with virtually no risk. If you’re nervous about banks and think you might be better off keeping your cash under the mattress, don’t. Almost all banks in the U.S. that offer this type of account are FDIC-insured, which is a guarantee by the U.S. government that your money is safe even if the bank fails (up to $250,000 for individual accounts).
For the financially inclined, there are other options you can use for your emergency fund. However, I would argue that most aren’t worth the extra mental effort and coordination. The goal of this bucket isn’t to grow a fortune or buy a private jet. It’s a simple safety net, and once you have enough to cover your ass you can pause contributions to it. A high yield savings account is the simplest way to satisfy this requirement and has the added benefit of protecting against inflation. Wherever you park your money, make sure it is readily accessible and won’t decline in value.
Bucket 2: Intermediate Savings
The least well defined bucket of the three, this bucket will look different to everyone based on their individual goals. I think of this bucket as money that will be used for any big purchases in the next 1-15 years. My personal intermediate bucket includes a down payment for a house, a down payment for a car, and a travel fund. Your bucket might include all or none of those. Since the time horizon for this bucket is longer, and you already have emergencies accounted for in the first bucket, the money stored here does not need to be as liquid as bucket 1.
With less liquidity constraints and a longer time horizon, you have more options for storing your money. The various options include high yield savings accounts, certificates of deposit (CD’s), bonds, stocks, and others. I won’t go into great detail on each of these as that could be an entire series of posts on it’s own. If you want to learn more about any of these options, or investing in general, Investopedia and Nerdwallet are great resources. What you really need to know is that the closer you get to when you plan on using the money in this bucket, the less volatile you will want your assets to be. To give you an idea of how to approach this on your own, I’ll talk about my own intermediate bucket money and some general guidelines.
Where I Save My Intermediate Savings
As I mentioned before, my intermediate savings bucket consists of funds for a down payment on a house, car, and money for traveling. I keep about 50% of my down payment money in a high yield savings account because it’s simple, can’t decline in value, and recent yields have been above inflation. This also allows me to have some liquid funds available for any financial opportunities I come across. The rest of my down payment money is in a mix of investments in the stock market and crypto. These assets are more volatile, but also have higher returns. I am ok with the additional risk and volatility because I don’t have a definitive plan for when I’ll purchase the house or car. Until I have a better idea of when I’ll need the money I’m content with putting some of this money in investments for growth.
Travel money is kept in a joint high yield savings account that I share with my girlfriend. We typically use the money we save for traveling within a year or two of tucking it away so we don’t try to get fancy with it. Current high yield interest rates are high enough for us to be satisfied but if they lessen in the future we may switch to alternatives like CD’s or bonds.
In general, the further away you expect to use the money in this bucket, the less liquid it needs to be and the more volatility you can withstand. If you’re saving for 10 years from now, it’s worth exploring investment options that can generate higher returns, like investments in the stock market (more on this in the next bucket).
Bucket 3: Freedom
Freedom at last. My favorite bucket to talk about. The goal of this bucket is to fund the life you’d live if you didn’t have to worry about making more money. The easiest way to get to that point is by investing for the long term. Most people do this in a tax-advantaged retirement account, of which there are many types. You could also have funds for this bucket in a traditional investment account, although you’ll likely pay more in taxes. I’ll make a separate post about all the types of retirement and investment accounts, and when I do I’ll link it here. For now I’ll tell you about some first principles to keep in mind when choosing where to save for this bucket.
Principle # 1
This bucket is for the LONG TERM. Let me repeat. LONG TERM. No get rich quick schemes. I’m talking about boring well-diversified stock market investments that you contribute to every month for decades but otherwise forget they exist. Don’t watch the stock market every day. It doesn’t matter. If prices go down that means you’re buying stocks on sale. Sometimes, stock prices will decline for a whole year and that’s ok. Short term fluctuations don’t change the fact that over last 100 years, returns of a well-diversified portfolio in U.S. stocks average about 10% per year. What you care about is what they’ll look like 30-40 years from now, not any given year.
Principle # 2
Don’t pick your own stocks. If you’re reading this you are probably new to investing and you will be shit at picking stocks. It’s ok I am too. Lucky for us, we don’t have to. We can invest in funds that give us exposure to a well-diversified portfolio of stocks for extremely low cost. I personally invest in a handful of Vanguard funds in my retirement account.
Side note- If you are interested in stock market investing and want to practice, do it in a separate account with money you are prepared to lose. Even better, trade with paper (fake) money at Charles Schawb before you try it for real.
Principle #3
Avoid fees at all costs. Management fees are like the bubonic plague for investment returns. Most asset managers that charge significant fees don’t justify their cost by having better performance. You won’t find any funds with zero fees, but you can get pretty close. The reason I invest in Vanguard funds is because their fees are phenomenally low.
Principle #4
Take advantage of employer matching. Many employers help their employees retirement funding by matching their contributions up to a designated limit. If this available to you, take advantage of it. You should be planning for retirement anyways, so this is free money.
Principle #5
Maximize time. Time in the market beats timing the market, every time. If you’re 18 and reading this, recognize that money you invest for retirement right now will have 42 years to grow. To give you some context, the S&P 500 index, which is a grouping of the 500 biggest companies in the U.S. stock market, was trading around $180 40 years ago. It’s now worth $6,013. That’s roughly a 3,340% increase in value. Take advantage of your time.
Final Thoughts
One quick note I’d like to end with is the boundary between all these buckets is often only in your mind. You can certainly have separate accounts for each and every financial objective, but you don’t have to. Some accounts, like retirement accounts, will be on their own by nature. Others, like your emergency fund and intermediate savings, might occupy the same high yield savings account The separation of your finances into separate “categories” is just a useful tool to help you plan and organize. At the end of the day it’s all still your money, and you can move it around as you see fit.
I hope this post is helpful to you when choosing where to save your money. Remember that everyone’s journey is different and this is just what I’ve learned through managing my own finances. Feel free to take whatever is useful to you and discard the rest.
That’s my Twenty2 for this week.
Until next time!
– Chris