Saving money is a good thing. But if you're hoping to build wealth, you not only need to save some of what you earned, but you also need to make the money work for you. That means you need to go beyond sticking it in the bank, where the return on investment you earn may not even keep pace with inflation.
Instead, you need to invest at least some of it in the stock market. Here's why.
Investing is the key to building a big nest egg
For most people, the purpose of saving money is to provide financial security. This includes short-term peace of mind that comes from knowing you've got an emergency fund. But it also involves building a secure retirement nest egg that leaves you with enough money for your later years.
Unfortunately, if you're trying to build that nest egg just by putting money in the bank, you're going to have to save a small fortune. And many people simply aren't going to have the cash to do so.
If you want your money to work effectively for you, it has to earn a good return so you can put the power of compound interest to work. And the stock market has historically been the best way to do that while minimizing risk.
The market has provided around 7% average annual returns over time, and you can most likely expect it to continue doing so for the foreseeable future. On the other hand, if you're putting money in the bank, you'd be lucky to see 2% annual returns.
If you're hoping to save a $1 million nest egg (which is a good amount for many people), the difference between earning a 2% return and a 7% return may determine whether it's even feasible to hit your goal. Say you started investing at 30 and needed your $1 million by age 65. You'd need to set aside around $20,000 every year if your saved money earned a 2% average annual return. But if you earned a 7% return, you'd be looking at a much more feasible $7,250 annual contribution.
How much of your money should be invested?
While it's easy to see why you need to invest, it's harder to determine how much of your money should be put at risk. Fortunately, there are a few simple rules you can follow if you aren't sure about the best approach to asset allocation.
First and foremost, don't invest any money you'll need within five years. The market goes through cycles, and you don't want to buy in at the start of a crash but not have time to wait for the recovery. If you can hold stocks for the long term, you significantly reduce the chances of big losses.
You'll also want to make sure you have an appropriate percentage of your portfolio in stocks, while keeping some money in other investments such as bonds. By diversifying into different asset classes, you can achieve a good balance between risk and potential reward, and maximize the chances some of your investments will perform well even if others perform poorly.
The right investment mix for most people can be determined by subtracting your age from 110 and putting that percentage of your portfolio in the market. If you're 40 years old, therefore, you would put 70% of your investment dollars into the stock market.
Of course, these are just general rules of thumb. If you want to take the time to develop a more personalized strategy for determining your risk tolerance and deciding how to allocate your assets, you may be able to devise a better approach. But if you aren't sure where to start with that, these basic rules make things easy. Use them today to decide how much you need to invest, then get started putting your money into the market where it can help you build wealth.