The Basics of Saving and Investing

One of the first rules of money management is to “live within your means" by spending less than you earn. Some people spend their entire adulthood in pursuit of that balance. But if you've already mastered the basics and have money left at the end of each month, you're likely ready to put your money to work with savings and investing accounts.

Here are a few key strategies and fundamentals of saving and investing that you may want to consider.

Pay yourself first

Many people get caught up in a cycle of consumerism where they spend almost all of their income, or, in the case of people who have credit card debt, they spend even more money than they earn. Saving is the exact opposite of this mindset. When you start saving money, you should pay yourself first. Before you spend one dollar of your paycheck on a restaurant meal or daily latte, put some money into savings.

Saving money is an act of paying your future self. With the magic of compound interest, even a small amount of savings can lead to big results in the future.

For example, if you save $25 per week (about the cost of two fast food meals), in 25 years you'd have $55,237! If you can save $75 a week ($300 a month), after 25 years you'd have $165,709. And if you can save $125 a week ($500 a month), after 25 years you'd have $276,181. (This assumes that you’d earn a hypothetical 4% annual compound rate of return on your savings.)

With savings, even a small amount — left alone to grow over time — can add up.

Types of savings accounts

There are three main types of basic savings accounts, which earn interest on the money you keep in the account.

1. 1. Bank savings accounts

   tend to pay some of the lowest interest rates compared to other types of investments, however your money in these accounts is generally very easy to access and is often FDIC insured (up to certain limits), so there is a low risk of losing money.

    

2. 2. Money market accounts

   pay you an interest rate on your savings, based on a complex range of factors related to how much money you have in the account and the current level of market interest rates.

    

   Money market accounts can offer higher interest rates than basic savings accounts, but they also tend to require a minimum balance — such as $1,000 or $5,000 — and they might not be FDIC insured, so it is possible to lose money with this investment. However, in general money market accounts are considered low-risk investment for holding your cash savings, especially if the money might be needed on short notice (such as for emergencies).

    

3. 3. Certificates of deposit (CDs).

   CDs are another option for saving money in a low-risk/low-yield investment. With a CD, your bank pays you a fixed amount of money during a fixed amount of time. For example, you can get CDs for six months, one year, two years, three years or more, and the longer you choose to leave your money invested in the CD, the higher the interest rate you receive.

    

   CDs tend to pay higher interest rates than savings accounts and are low risk; however, the drawback is that you have restricted access to your money. If you sign up for a five-year CD and then realize after one year that you need that money, you might have to pay an early-withdrawal penalty for cashing out your money from the CD.
   
   If you want higher returns and can tolerate higher risks, it might be time to look beyond these simple savings vehicles and consider investments such as stocks and bonds.  

Bonds

When you invest in bonds, you’re essentially lending money to a government (state, federal, city or county) or corporation, then the borrower agrees to pay you (and all its other bondholders) back over time. As a bondholder, you can receive regular income from the bond in the form of principal and interest payments, unless the bond issuer defaults (such as if a company goes bankrupt).

In general, the higher the interest rate on a bond, the riskier the investment. If your bonds are highly rated — i.e., ratings companies believe the bond issuer is financially strong enough to repay its debts — they're generally considered lower risk. U.S. Treasury bonds are generally considered to be the safest type of bond investment because they are backed by the full faith and credit of the U.S. government.

Many people invest in bonds (along with stocks) as part of their overall retirement savings portfolio. But remember: Bonds are not guaranteed investments.

Stocks

If you already have an emergency savings fund (usually three to six months of expenses), then you might want to start investing in stocks. Stocks are one of the most common forms of investments for people who are saving for retirement.

With stocks, you own a share of a corporation, which entitles you to a share of the company's profits. When the company pays a dividend to shareholders, you get more money in your account. When the company's stock price goes up, so does the value of your investment.

Stocks can be risky and are not guaranteed to go up in value. The price of stocks can go up or down, and sometimes the stock market fluctuates rapidly — known as market volatility.

It can be risky to have too much money invested in too few companies — any individual company's stock can go down. You may want an investing strategy that includes more diversity to help with the risks of an undiversified portfolio. So, it could be time to consider mutual funds.

Mutual funds

Mutual funds are professionally managed portfolios of stocks, bonds and other investment assets (such as money markets, real estate or precious metals). When you invest in a stock mutual fund, you buy shares in a fund that owns shares of different companies, so you end up owning little pieces of a multitude of companies. This gives you broad diversification in your portfolio and lets you benefit from the profits of the corporate world, while (hopefully) managing and reducing your risks.

However, mutual funds can be risky. There are no guaranteed returns on your investment in mutual funds. Mutual funds can also be complicated; it's important to do your research and understand the fees and risks of each fund, as well as to build a portfolio of investments that suits your overall financial goals. For example, if you have 30 years left until retirement, you may want to aim for a portfolio with a larger percentage of stocks and a lower percentage of bonds. Stocks often have a higher rate of return than bonds over the long term but also have greater risk, so as you move closer to retirement, your “safer" bond and cash investments should increase while you dial down the number of stocks in your portfolio. You should review your portfolio periodically to ensure it is meeting your objectives.

A good financial planner or brokerage can help you evaluate your options for mutual funds, depending on your age, income, investing goals and risk tolerance. Also, try Prudential’s retirement investment persona tool to evaluate your preferred investment style, find out how much risk you're comfortable with, and figure out which types of investments are right for you.

Footnotes

Ben Gran is a freelance writer based in Des Moines, Iowa. He writes about personal finance, financial services, technology and business.

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