Generally, it is wise to start investing some funds almost as soon as you start earning them. When it comes to saving for retirement, this should typically top the financial priority list for most Americans. But what should you do with a bonus check or tax return? The decision to save, spend, or invest excess cash really requires further analysis.
Consider Saving If…
….you have a short time horizon or haven’t adequately funded your emergency reserves, you may want to consider saving your windfall cash.
Emergency Fund – Before investing surplus cash, it is wise to have fully funded your emergency reserves. There are ways to invest this cash safely for a very modest return. Money market accounts can be a good place to hold emergency funds. In today’s low interest rate environment, your cash reserves may be best off earning interest in a traditional savings account.
Short Time Horizon – Shorter investments tend to be riskier because if the market plummets, you will not have much time for it to recover, as in longer-term investments. Also, if you know you need the cash in the short term, your asset allocation will be more conservative than your risk tolerance would otherwise warrant. Given these factors, and the impact of taxes, trade fees, and potential commissions, it may not be beneficial to invest these funds in the market. Don’t like the idea of paying your advisor commissions? Fee-only financial advisors do not accept any commissions or sales charges.
Consider Investing If…
….you have a medium to long term time horizon, adequate emergency reserves, and are on track with your retirement contributions, consider investing your excess cash in the market.
Principles of Compounding – Compounding is essentially when interest earns interest, and time can either work for or against you. Investing even small amounts over a long period of time (decades) usually leads to substantially more money than investing larger amounts in shorter periods of time. According to U.S. News & World Report, “money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.” Starting early will not only put your asset to work for you, but will also give you the long time horizon needed to weather inevitable market swings.
Weighting the Time Horizon – Overall, people who invest over a long time horizon, using a balanced and diversified allocation strategy, tend to be better off in the long run than investors who chased returns or started too late in life. Strategies such as portfolio rebalancing and tax loss harvesting can really help ensure your portfolio is both diversified and tax efficient over time.
Consider Spending If…
….by spending, what we really mean is use the surplus cash to pay down debt. Depending on your situation, it may make sense to pay down outstanding debt versus investing cash. If you have a very low risk tolerance or need to lower your debt to income ratio, consider paying off some debt.
Risk Tolerance – When planning to invest, you should consider an appropriate investment based on your personal risk tolerance. If, based on your very conservative risk tolerance, you think you may be able to earn a 2% return annually, consider instead using the cash to pay down the principal on a loan with an interest rate of 5%. Compounding works both ways, and your outstanding balance (and subsequent interest payments) will be reduced, thereby effectively guaranteeing this rate of return.
Lower Your Debt-to-Income Ratio – If you’re looking to buy a house in the near future, coming up with a down payment is the first priority. Your second priority should be ensuring you qualify for the lowest interest rate available. If your debt-to-income ratio is a bit too high, do some quick math and determine whether using the extra cash to pay off debt would make an impact. Carrying a credit card balance? Paying that off could help your credit score, and debt ratio, almost instantly.
While investing is a wise choice to secure your financial future, you should consider many factors before committing. Figure out your finances, and account for any unexpected expenses that may come up. Also, remember that investing is always risky, and how much risk you wish to assume is up to you. However, with a long time horizon and a diversified asset allocation strategy, it may make sense to put your excess cash to work for you.
The material contained in this article is for general information only and should not be construed as the rendering of personalized investment, legal, accounting, or tax advice.
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