Keeping your hard earned cash "safely" on your bank account is a no brainer for many people. But it's an illusion to think one's money is safe just laying in a bank account. Reality is unfortunately, that especially in today's time with negative interest rates, keeping all your wealth in your bank account will eventually cost you money. But, before locking in hard earned money, one must first understand why they are doing it.
Let’s look at a very general situation. Let’s imagine our spending as humans in relation to our age: our lifespan from 0 to 100 years old. Of course, everyone’s spending pattern is different, but there are general trends.
When we are kids, we don’t have hobbies, but we have basic needs. As infants and young children, our costs of living are very low. But with time, we start going to school and requiring more items to supply our learning. We also start having more and more social activities, and some of those cost money. Then, we go to college, and maybe start paying our own rent. Our costs go up again.
After college, we have to pay our tuition, get married, have kids… all at a cost. We invest, get a bigger apartment, go on vacation, start eating out at restaurants more often. Our spending continuously goes up throughout our lifetime, but only up to a certain point. When we don’t have kids to care for anymore, our spending starts going down again.
That’s our spending curve. But how do we afford all of these things? We earn income to counteract our spending. And the earnings curve looks different. To sustain our lifestyle, we need to find a way to balance our earning and our spending. When we spend more than we earn, we need to have enough income to sustain our spending habits.
Many people don’t plan ahead, that they'll produce less income in the later stage of their lives. In this case, they either have to reduce their spending habits or, if they are lucky, get support from their children. But if we are seeking complete financial independence, they need to hold enough savings to make up for the earning deficit towards the end of our lives. With the life expectancy rate going up every year, this amount of time gets longer and longer. And we have to account for it.
There’s another big player in this scene: inflation. If you keep your money under the couch, the amount you have today will be valued less next year. This is where investments come into place. For the value to go up, the money needs to circulate into the economy. There are many investment instruments out there, some safer than others. When looking at higher yearly returns, one must be comfortable with the risk associated with it.
Before investing, one must ask themselves the following two questions:
When building a solid investment portfolio, risk must be taken into account. How fast do we need a return, and how much are we willing to lose in case some investments don’t do well short term, without hurting cash flow?
For example, when retiring at 60 and expecting a certain pension, how much money would you need in addition, to maintain a comfortable lifestyle for the rest of your life? That would be a long term strategy. You might as well have short term strategies at the same time. Let’s imagine the goal is buying a car in a couple of years. Then, are you flexible with the time of purchase, in case some of your more volatile investments go up in value? And how does this large spending affect your savings?
At the end of the day, everyone’s goals are different, which implies different risk levels. But we know for sure that, by smartly investing our money with a sound strategy, our money can work for us and generate passive income. And if we are not investing our money back into the economy, they will lose some of its value. Therefore, not investing has a bigger associated risk than investing with safe methods (eg. bonds).
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We believe everyone should have the access to financial diversification, and education in this area is vital throughout the path to financial freedom. If you enjoyed this article, share it with a friend that would enjoy learning more about financial strategies!