Even if you are among the few who live by the age-old wisdom of "saving for a rainy day," your savings probably will not be enough. Two important reasons why your financial plan should not be limited to saving are:
- Inflation will reduce the purchasing power of your savings over time.
- To reach your financial goals, you may need the added growth potential that investing offers.
Although the words saving and investing are often used interchangeably, they are two distinct financial activities - each serving a different purpose. Saving is generally geared toward preserving capital, while investing typically aims at accumulating more capital.
Two different strategies
The main purpose of saving is to preserve money safely. You will want to make sure you have easy access to your savings - that is, liquidity - in the event of an emergency. Common vehicles for saving are CDs, money market accounts, and traditional bank savings accounts. Each offers a safe place to put aside money while also maintaining ready access to it. Savings instruments are usually government-guaranteed up to a certain dollar amount and, therefore, represent little or no risk to savers.
The trade-off for security and liquidity, however, usually is a low rate of return. This means that, over time, the purchasing power of your savings is likely to be diminished by inflation - possibly a significant amount. The average annual inflation rate over the past four decades has been approximately 4.5 percent, according to statistics cited in the April 24, 2000, issue of Business Week. In effect, you pay for security and accessibility with a loss of future purchasing power.
A major purpose of investing, on the other hand, is to increase your capital. Investing may help you beat inflation and provide you with the growth potential you need to reach your long-term financial goals, such as a comfortable retirement. When investing, you commit assets in exchange for a hoped-for financial return. Common investment vehicles include stocks and bonds, mutual funds, annuities, and other securities.
While past performance is no guarantee of future results, historically stocks and stock funds have outperformed other investments, such as bonds and money market securities. The January issue of Money Magazine noted that since 1926 large U.S. stocks have gained an average of 11.2 percent per year. However, because the value of stocks fluctuates in the short term, investing for growth in stocks is generally most effective for the long term. Diversification - spreading your money over several different types of investments - helps reduce your exposure to market fluctuations.
Unlike savings, most investments are not federally insured, and they offer no guarantee of preservation of principal. They are also likely to be less liquid than most savings vehicles. In addition, purchasing stocks and mutual funds usually involves a commission or sales charge.
Many financial advisors recommend keeping an emergency fund in traditional savings vehicles and investing the rest to seek higher returns for future goals. A well-diversified financial plan will combine both savings and investing, giving you both the liquidity to meet short-term needs and enough growth potential to meet your long-term goals.
Do you consider yourself to be a "bargain hunter?" Someone who looks for high quality at a low price? Finding a good deal applies to more than just your shopping list. In fact, this value strategy may also have a place in your investment portfolio. As some overvalued sectors of the current stock market have recently deflated, value investing may come back in favor among investors.
When you consider the allocation of your investment portfolio, you may choose to diversify beyond your mix of asset classes, such as stocks, bonds, or money market funds. You may also choose to diversify based on style. The two primary styles of stock investing include growth and value. Which one is appropriate for your portfolio today?
Growth investors search for companies with accelerating revenues and earnings relative to their industry and the economy. While a growth strategy may help you increase your portfolio performance, it may also expose your portfolio to a higher level of risk - in both weak and strong markets.
In today's market, when a slowing U.S. economy threatens to impact corporate profits - thus affecting the stock market - investing in value may help cushion your portfolio from significant declines in the growth sector. With a value investing strategy, you may purchase shares considered undervalued in the current market, yet they have a high potential for achieving continued revenues and profits.
According to Hank Herrmann, chief investment officer of Waddell & Reed Investment Management Company, a subsidiary of Waddell & Reed, "One of the best ways to understand value investing is to consider a company's intrinsic value and relate that value to its share price." Herrmann added that intrinsic value may be measured by a company's book value, which you can find by evaluating its financial statements. Based on this and other factors, such as a company's business plan, management team, and assets (such as land, property, patents, or other investments that may provide hidden value), you may determine that a company has continued earnings potential.
Typically, value stocks are those of well-established companies that have already survived their risky start-up phase. They often have well-embedded earnings and may be more inclined to pay a dividend to shareholders rather than reinvesting for growth. Despite being undervalued in the current market, value stocks are often steady performers that may be poised for a bounce when the market begins its upturn.
It is reasonable to say that most portfolios would benefit from some application of value investing. And incorporating value should be a part of your overall allocation strategy. In other words, if portfolio growth is still one of your top investment objectives, growth stocks and stock funds should still comprise a large percentage of your holdings. However, adding value to the mix may help moderate the performance uncertainty that may be associated with growth investing.
Kathleen Adams, RDH, BS, is a financial adviser with Waddell and Reed (www.waddell.com). She is currently trying to initiate money-management workshops for hygiene students and specializes in working with dental professionals. She can be reached at (800) 210-1357.