by Maurie Backman | Nov. 21, 2019
There comes a point when socking away more money in the bank doesn't make sense.
We all need money on hand for unforeseen expenses -- things like automobile malfunctions, home repairs, or unexpected medical bills. In fact, your primary financial goal should be to build an emergency fund with enough cash to cover three to six months of essential living expenses.
But what if you're able to keep putting money into your savings account beyond the upper limit mentioned above? Is it wise to keep piling up cash in the bank?
Although it's smart to have a larger emergency fund than usual in some cases, you shouldn't let your savings account balance climb too high. If you do, you'll miss out on the opportunity to score a better return on your money.
When you don't invest, you're effectively losing out on money, because you don't give your savings a chance to grow. And that's precisely what happens when you keep too much money in a savings account.
Of course, the upside of a savings account is that the money in it is available at any time and that the principal sum you sock away is protected from losses. This isn't the case when you invest your money.
When you invest through a brokerage account, there's always the risk that your account balance will take a dip when market conditions decline or when an investment underperforms. That's why keeping your emergency fund in stocks is a bad idea -- the market is too volatile to make that a safe bet, and if you wind up needing money at a time when the market is down, you risk taking major losses.
That said, once you've socked away enough money to cover six months of living expenses, you shouldn't continue to put your spare cash in the bank. Instead, you should invest that excess cash so that it grows into an even larger sum.
Imagine you typically spend $4,000 a month on living expenses and therefore want a $24,000 emergency fund. Now, let's say you're able to save up $10,000 more on top of that $24,000. If you put it into a high-yield savings account paying 2% interest (which is consistent with today's top rates) and leave it alone for 10 years, you'll grow that $10,000 into $12,190.
But watch what happens if you invest that money instead. The stock market's historical average is around 9%, but let's be a bit more conservative and assume that if you put that $10,000 into stocks and let it sit for 10 years, you'll score a 7% average annual return instead. In that scenario, you'd be looking at $19,672 rather than $12,190. That's a sizable difference.
The gap between a savings account and an investment account gets even wider over time. Leaving that $10,000 to earn 2% in a savings account over 30 years will result in a balance of $18,113. But in a brokerage account invested heavily in stocks, that $10,000 could easily grow to $76,123 over 30 years, assuming a 7% average annual return during that time, leaving you $58,000 richer.
Now, there may be circumstances under which it pays to save more than six months of living expenses for emergencies. For example, if your income varies and you tend to have periods of low or nonexistent earnings, then socking away nine to 12 months of expenses in the bank could make sense.
But once you're satisfied that your emergency fund is complete, do yourself a favor and invest the rest of your money. If you're not comfortable completely loading up on stocks, assemble a diversified portfolio that includes bonds, REITs, or other vehicles. The key is to score a higher return than what even the most generous savings account out there will give you.
Let's be clear: A healthy savings account balance will serve you well. Just don't let that balance get so high that you miss out on wealth-building opportunities.
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