|Step 5: Invest Diversely
You know where you should store your emergency fund, but where should you put your savings for other goals? There are three main types of investment classes:
Stocks: A share of stock represents a percentage of ownership in a corporation. In other words, if a company is divided into a million shares and you buy one share, you would own one millionth of that company. You can make money from receiving dividend payments and selling the stock for more than you bought it for. Historically, stocks have provided the greatest return (earnings) long term. However, there are no guarantees – one day your stock may be worth more than what you paid for it, the next, less.
Bonds: A bond is a loan to a company or government, with you, the bondholder, as the lender. Organizations issue bonds when they want to raise funds. Generally, you receive the principal, called the par value, at maturity of the bond and interest periodically while you are holding the bond. Depending on the market, you may purchase a bond below, at, or above its par value. In general, bonds are between stocks and cash equivalents in regard to risk and return.
Cash equivalents: Cash equivalents are assets that can be readily converted into cash, such as savings and checking accounts, certificates of deposit, money market deposit accounts, and U.S. Treasury bills. They tend to be low-risk, so there is little or no danger that you will lose the money you deposit. As a result, cash equivalents provide a low return.
It is best to keep money for short-range goals in cash equivalents. Because you will be using the money soon, your primary concern is that you not lose any of your principal investment. If you put your money that you need in six months in stocks, there is a decent chance the stocks will be worth less when you sell.
For long-range goals, the value of your investment in six months is less of a concern than inflation, which is the general rise in the price of goods and services over time. The return on cash equivalents is very often less than the rate of inflation, meaning if you keep your money there, its value will be essentially decreasing over time. That is why it is a good idea to put a large chunk of the money you are saving for long-range goals in stocks and bonds, which, on average, have a higher return than cash equivalents. There is a risk that the value of your investments will decrease, but the risk is lower the longer your investment period is. Inflation can be a concern for mid-range goals, but since the timeframe is shorter, you may want to be more conservative with your investment choices.
A good way to reduce the risk of losing money when you invest is to diversify. A well-balanced portfolio has a mixture of stocks, bonds, and cash equivalents. (What the exact percentages should be depends on how far away you are from your goals and your risk tolerance.) It is also a good idea to diversify within each type of investment class. For example, you can purchase stocks from manufacturing companies, technology-oriented companies, and financial services companies. A simple way to get diversity is to purchase shares in a mutual fund. In a mutual fund, money from several investors is pooled to buy different stocks, bonds, and/or cash equivalents.
Take advantage of tax-deferred accounts when they are available. For example, for retirement, use a 401(k) or 403(b) if your employer offers it, or you can set up a traditional IRA or Roth IRA on your own. If you are saving for your child’s higher education, you can use a Coverdell Education Savings Account or 529 plan. All of these accounts allow your earnings to grow tax free. 401(k)s, 403(b)s, and traditional IRAs allow you to make tax-free contributions, while Roth IRAs, Coverdell Education Savings Accounts, and 529 plans allow you to make tax-free withdrawals.
Step 6: Make Sure You’re Covered
Events such as a severe illness, car accident, or house fire can put a serious cramp in your financial health, even if you have savings. Having the right amount of insurance will help protect you from the financial consequences associated with many of life’s adversities.
Health insurance is something everyone should have. Many employers offer group health insurance to their workers and, in some cases, their dependants. You may have to pay a portion of the insurance premium, but in most cases you’ll pay far less than you would if you had to buy a policy on your own. What if you are not able to get insurance through work and cannot afford a comprehensive policy on your own? If your income is below a certain limit or you are pregnant or disabled, you may be able to get coverage through Medicaid or a state health insurance program. Another option is to purchase catastrophic medical insurance. Catastrophic medical insurance does not cover routine medical costs, like prescriptions and doctors’ visits, but it does cover major medical events, like hospital stays. The deductibles are usually high, but the premiums are low.
If you are employed, it is a good idea to have disability insurance, which replaces a portion of your income if you are unable to work. There are two types of disability policies: short-term, which only provides coverage for a limited period of time (usually up to six months to two years), and long-term, which provides benefits until retirement age. Long-term insurance is the most important insurance to have. If you are only out of work for a few weeks, you should be able to pay for your expenses with savings. However, if putting aside money in savings is a struggle, a short-term disability policy could be a helpful thing to have. Check to see what coverage you have through work before purchasing a policy on your own.
If you have a spouse, child, parent, or anyone else who relies on your support, this is something you should consider having. Life insurance is not just intended to replace the wages you provide but services as well. (For example, a stay-at-home mother may want to purchase life insurance to pay for child care if she dies.) There are two basic types of life insurance: term and cash-value. Term insurance is pure life insurance. You pay the premiums for a specific period of time, and the only way the policy will pay out is if you die. With cash-value life insurance, part of your premium goes toward the policy and part of it goes into a savings plan. You can keep the policy as long as you pay the premiums. You can also borrow against the money in the savings plan or cancel the plan and get the cash back. However, generally, the premiums are higher for cash-value life insurance, and it may not be worth the extra cost if you don’t anticipate needing life insurance for the rest of your life.
In most states, the law requires that drivers have at least liability auto insurance, which covers your legal costs (up to a limit) if you injure a person or damage property with your car. If your car is several years old and worth little, liability coverage may be adequate. However, if your car is newer, you may want full coverage insurance. (This will likely be required by your lender if you have a car loan.) In addition to liability coverage, it typically includes medical expenses coverage, uninsured motorist protection coverage, collision coverage (which pays for repair costs or replacement due to accidents), and comprehensive coverage (which covers repairs costs and replacement due to damage resulting from other causes, such as theft or fire).
If there is a mortgage on your property, your lender probably requires you to have homeowners insurance. Even if you do not owe anything on your home, allowing the insurance to lapse would be a grave mistake. For most homeowners, their home is their greatest asset – without insurance coverage, a disaster could lead to financial ruin. Homeowners insurance generally provides coverage for fire damage, theft, and liability (useful when your child hits a baseball through the neighbor’s window). Regular homeowners insurance policies do not cover losses resulting from earthquakes or floods. If you are in an area where either of these is a concern, you may want to purchase a supplemental policy.
Renters insurance covers personal property loss and liability for renters. This insurance is relatively inexpensive, especially compared with what it would cost you to replace all your clothing, furniture, electronics, and other property if they were stolen or damaged. Don’t assume that your landlord’s policy will cover your losses – in most circumstances, it won’t.