Saving is a very important part of creating wealth. You cannot create wealth without some form of savings.
We have seen that we save money for an emergency and specific short-term goals, such as a vacation.
We also need to know our money is readily available without a capital loss. In this case security is more important than returns. That is why we keep as little as possible, but as much as needed in savings.
When I think of the South African situation (and I assume it applies in most countries), there are three places or options to save your money (as opposed to investing).
First would be a normal commercial bank, second would be “lending” bank and third a Money Market Fund.
For a moment I just want to focus on the “lending bank.” A commercial bank has a very diversified business portfolio with individuals, businesses and a varied service and product offering. A “lending bank” is a bank that focus on lending money to consumers. They take your deposit and lend it to other people who want to buy anything they cannot really afford (a very crude generalization). Since they charge hefty interest, they pay good interest.
I would ask at least the following questions before I start my savings account:
- If it is a bank, is it a commercial bank or lending bank? I think I have a bit more risk with a lending bank.
- Is my money in any way guaranteed? In some instances the Central Banks guarantee bank deposits. Unfortunately, banks can also go bankrupt!
- What fees are involved? Do I pay a deposit fee, withdrawal fee, transaction cost or admin fee? It might just be better to keep my money in a safe in my house if costs will erode my capital!
- Are my money tied up for a specific period, or can I withdraw when I want? If it is a fixed term investment, can I withdraw earlier, and if so, what is the penalty?
- How is the interest calculated and how is it capitalized? You can read about it here. The best option would be daily balance capitalized daily. Then you really earn interest on interest.
- What is the interest on the investment? Does it change as my investment change?
Always keep in mind the purpose of this savings account. If we are talking about an emergency fund, you will hopefully never need it, but if you do, you need it immediately. You need all of it, without a capital loss. It is the worst when people use the stock market for emergency savings and they need the money in a crisis and the markets have dropped and they have to sell at a loss.
|Reading The Millionaire Next Door will give you good perspective on growing wealth.
Also remember that risk does not mean why should avoid something. It means we should diversify and limit exposure.
If you are saving towards a specific short-term goal, then you want to limit risk!
The amount of money you need in an emergency fund is very personal. It depends on many factors and is best discussed with a financial advisor.
I will use an example and say I need an emergency fund of $6 000 (a random figure). I reckon I need to have about $1 500 available at any time for stuff that breaks (like the stove or fridge). I will leave this money in a savings account and earn very little interest. I might even keep my initial savings in an envelop to protect me from losing out on fees.
Assuming I will be able to tie myself over for 30 days once I have used the initial $1 500, I will put $1 500 in a 30 day notice deposit account. It should earn me more money.
Th balance I will keep in a Money Market fund. Money Market funds do have a difference between the buy and sell price. You need to keep your money invested for some time before the interest makes up the difference. But Money Market Funds are generally low risk and pays a better interest.
BUT: when African Bank in South Africa went under, we also realised that there is some capital risk involved with Money Market Funds! Albeit a very small risk, it is there.
WHAT ARE WE DOING?
What is happening here? I want to be responsible and protect my long term financial plan. I do not want to borrow money to pay for repairs and other emergencies. I provide a fund. This is money that will be very unproductive most of the time. On an emotional level it is very productive! Financially I want to keep my risk as low as possible and my returns as good as possible.
That is why I ask the questions and I allocate my money based on the answers to the questions.
What do you do with excess money, once you have provided your emergency fund? You invest it for better returns!
Please, please, do not start making changes to your portfolio without consulting your financial advisor! Financial planning is a holistic, personalized process. I just give you ideas to make you think. Use these ideas as a foundation to discuss your options with a person who can help you implementing it in the best way for you.
If you have any questions, please leave them in the comments. I would like to hear from you.