Saving vs investing money
When you are young, the most important thing to do is optimize where you can save money and not over-optimize where you are investing. I'll give a quick explanation of how to think about this when you're young and don't have a large amount of assets yet.
Where should I invest my money? This is a question I get a quite often. My general advice to most people is, “dollar cost average into a low-cost ETF mirroring the S&P500, such as VOO or VTI and don’t check it until you retire.” Simply put, that means just invest the same amount on a recurring basis (every week, month, etc.) in an investment that covers the overall stock market. In general, this is probably great advice for the person who really doesn’t want to spend a lot of time thinking about finance.
I rarely give specific advice, because everyone has different priorities, goals, and relationships with money. Some people will lose their minds if they see their investment decrease by 50%, whereas others will see it as a great opportunity to buy more. I also don’t want to be the guy who gives specific advice to a friend and that friends ends up hating me if that investment goes south.
However, there’s one question I’ve never been asked, which is, “How can I save more money?”
There is a certain point in your journey where it makes sense to focus more time on Investing decisions vs. Saving decisions.
Early on, your time is most likely better spent on finding ways to save money instead of determining how to begin finding different investment opportunities. While many people begin thinking about the best place to invest their money, they should probably be more focused on finding the best ways to save more of their money.
Let’s think about it by using the two scenarios scenarios below. Which number is larger for you?
- The amount of money you can gain invested in a year?
- The amount of money you can save in a year?
To determine how much money you can gain in a year you want to multiply the money you have invested by the expected return you can expect to receive on your investment. For example, let’s say you have $10,000 to invest in the stock market. A reasonable expectation of what you can expect to earn in a year is 5%. With this, you should expect to earn $500 in the entire year (5% * $10,000). Doesn’t seem like a lot of money, right? I know people that are wearing Yeezys they bought for $700 that have less than that amount in their bank account. Your Yeezys just wiped out your entire year of gains, but at least you look cool.
Now let’s say that this same person earns $70,000 pre-tax per year. 20% goes towards taxes, so now you have $56,000 left. You have $56,000 to spend on rent, groceries, cell phone, and all of the other expenses that you have. Imagine you find a way to cut $100 out of your budget every month. That ends up in $1,200 a year in additional savings. That $1,200 is much larger than the $500 you can expect to earn in a year on your $10,000 that is invested in the stock market. With one small tweak of your budget and lifestyle, you have put yourself in a great position to get a better “return” because you are finding ways to save money.
Over time as you keep investing, your assets will grow to a point where this equation switches. If you have $2,000,000 invested, your expectation of that same 5% return results in a $100,000 increase. It’s probably harder to find ways to save $100,000 on your annual budget. You usually get to a point where you can only cut so much spend in your budget and you don’t want to always live so frugally. So at this point, your time is better spent finding ways to increase the expected return that you can get on your $2,000,000 portfolio. If you can find a way to get a 6% return vs. 5%, that results in an additional $20,000 that you earn from your investments. At this point, you may spend more time on seeking out different investment opportunities such as real estate, small businesses, startups, etc.
In the early days of investing your money and growing your wealth, first spend your time on finding ways to increase your savings. You can take these savings and invest it into simple investments if you are a novice. Over time, you’ll get to the point where your investing decisions will be more impactful than your savings decisions. Investing is extremely fun - it’s a great feeling finding great investing opportunities. But, in the beginning, spend more of your time on the savings decisions that will be more impactful so you’re setting yourself up well for the future.