How to Save Money and Understand Investment Options

As one of your regular expense items, you should include payments into a savings (or investment) account (pay yourself first). A good minimum savings goal is 10% of your gross income. The importance of this step cannot be stressed enough; given enough time, it can literally bring you financial independence.

A good guideline for knowing when you have enough savings and can begin investing is to ensure you have 3 months worth of living expenses in liquid savings (bank account, money market account, or short term CD) if yours is a dual-income household. You'll want 6 months worth of living expenses if you are the only breadwinner. Once you have your basic savings and have your retirement covered, you can invest.

Investments

Once you are living below your means and building up savings, there's the question of what to do with the money to create wealth. The following are some general investment categories in order from least risk to greatest risk.

Bank account: CDs, checking, etc.

Cash or money market funds

Debt investments: bonds and bond mutual funds

Common stocks and stock mutual funds

Real estate

Collectibles

Options

Futures

How Investment Categories Compare: Risks vs. Returns

Unless you're a near expert in finance, collectibles, options, and futures are likely to be too high risk.

Real Estate is a very localized investment with more "negatives" than many realize and often not easy to sell on short notice (non-liquid). However, it is - if bought, managed, and sold correctly-a great source of wealth.

Stock is probably the best general category to invest in for long term capital gain. Along with the increased reward potential comes increased downside risk in the short term. However, the risk of negative returns in stocks or mutual funds that invest in stocks decreases the longer they are held. Stock mutual funds are generally safer than individual stocks because of diversification and professional management.

Bonds usually have better returns than categories bank accounts or money market accounts and provide a good degree of safety. But know that within this one category the range of risk is wide, from junk bonds with the highest risk, to US Treasury bonds with the lowest.

Money Market Accounts, Bank Accounts, and CDs usually have returns that are near the rate of inflation. These are very safe, but do not afford a good return on your investment in the long run.

Allocating Your Investments

Once committed to investing, you should give top priority to setting your overall asset allocation. Basically, determine what portion of your investment capital should be used in each of three general investment categories:

Cash

Bonds

Stocks

(When referring to stocks or bonds, mutual funds that invest in these securities are included.)

A traditional rule for calculating asset allocation is to subtract your age from the number 110. The result is the percentage of your total investment capital that should be in stocks; the remainder of your portfolio would be divided between the other two categories in proportions dependent on your need for income (bonds) and liquidity (cash). For example, if you are 40 years old, 110-(40)=70. So, 70% of your total investment would be in stocks, 30% would be left to divide between cash and bonds.

Don't forget another important thing to plan for, especially if you are self-employed - estate planning. See my article here.

Read the next article in the series, How to Reduce Your Debt.

Source: http://www.stcsig.org/cic/OnlineBook/c17intro.htm