Money Management
November 11, 2024
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What is your thought process when considering saving or investing your money? Do you rapidly make the decision, or do you factor in your financial goals, risk tolerance, and overall financial well-being?
While there is no guarantee that you’ll make money from your investments, you still need to get the facts right from the start in order to make informed decisions, build a risk mitigation plan, and increase your chances of success.
One way of doing this is to be deliberate when choosing where to put your money, as it can impact your ability to grow or protect it over time.
This article will explore five important concepts to show you why where you save/invest matters.
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Where you put your money directly relates to your ultimate financial goals, which on a grand scale, involves capital growth or capital preservation.
Capital growth is an approach that primarily focuses on increasing the value of your investments over time. Here, you want your investments to generate returns that exceed the inflation rate and grow your initial investment to achieve your big-ticket goals, such as buying a house, retirement, and building generation wealth.
When your goal is capital growth, you will likely have to put your money in accounts and investments with higher potential returns.
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On the other hand, capital preservation is an investment approach that primarily focuses on protecting your initial investment and ensuring it maintains its value over time. For example, when saving to buy a fridge, you will likely put your money in a less volatile and easily accessible account.
This strategy is typically employed by individuals who are risk-averse or near their financial goals and don't want to risk significant losses. As such, they put their money in accounts/investments that at least keep pace with inflation to protect their purchasing power.
When seeking capital preservation, you will opt for less volatile investments that offer more stability. This strategy also offers higher liquidity than a capital growth approach.
Ultimately, your financial goals will act as a compass and help you define your approach. They will inform your risk tolerance, asset allocation, and the types of investments that align with your objectives. Simply put, where you put your money when saving for a December vacation will differ when saving for retirement.
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Knowing your investment time horizon can help you choose a suitable place to put your money in order to meet your financial goals. Time horizon refers to the length of time you plan to hold an investment before needing to access your funds.
When you have a clearly defined time horizon, you can gauge if you have enough time to recover from investment risks and if you have enough time to wait and earn maximum returns through compounding.
Typically, investment time horizons can be divided into three categories: long-term, mid-term, and short-term.
A short-term time horizon means you will need access to your funds within the next few months or years, a mid-term time horizon ranges from four to 10 years, and a long-term term is generally ten years or longer.
Different investment goals require different time horizons.
Short-term goals, like saving for a vacation in a year, may require putting your money in more liquid and less volatile investments. Long-term goals like retirement planning can allow for a broader range of investment options, including illiquid ones. A long-term time horizon also ensures maximum returns through compounding.
Determining your time horizon starts with knowing when you will need to use the funds. From here, you can put your money in an account/investment that will ensure it will generate expected returns, and you won't suffer any penalties when you withdraw it.
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The risk-return tradeoff is a concept that describes the relationship between the risk an investor takes and the level of returns they realize. The two move in tandem: as risk increases, so does the potential for higher returns. Conversely, the less risky an investment is, the lower the potential returns or rewards are likely to be.
Knowing the risk-return tradeoff can help you decide where to put your money, as it mainly considers your risk profile. It empowers you to choose an account/investment that matches your risk tolerance.
Conservative individuals opt for lower-risk accounts/investments for modest, predictable returns. Moderates strike a balance between risk and return, typically diversifying across asset classes. Aggressive individuals willing to accept higher risk pursue investments with potentially substantial returns.
The risk-return tradeoff will also help you justify a risk (or lack thereof) when choosing where to put your money. If you're taking a considerable risk, you will be able to know if the potential reward is worth it. On the flip side, if you put your money in a low-risk account/investment, you will do so knowing it won't bring in huge returns.
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This principle stems from the adage, "Don't put all your eggs in one basket." If you put all your money in one place, you increase your risk exposure. If that investment underperforms or goes up in smoke, you will make less profit or lose your initial capital.
Diversification is meant to help you overcome this risk.
Diversification is the process of spreading/putting your money in various accounts/investments with the expectation that the positive performance of some will offset the negative performance of others. The core idea is that by doing so, you can mitigate risk and enhance the stability of your portfolio.
This approach matters for several key reasons.
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The costs associated with an investment can significantly impact your overall returns. Most savings and investment accounts typically come with various costs, including, in some instances, account opening fees.
Depending on where you put your money, you might be charged trading, account maintenance, and transaction fees. All these costs can quickly add up and eat into your profits.
Some accounts might also charge you penalties for breaking the terms of your contract. For instance, if you liquidate a fixed deposit account before maturity, you might have to forfeit a portion or all of the interest you have earned. Or if you are putting your money in an insurance plan, you can be penalised if you delay paying the monthly/annual premiums.
Next, you need to understand the tax implications of where you invest to minimize your tax liability. Just like fees, tax on your returns will differ depending on the location of your money. For instance, while treasury bonds can attract a 10% to 15% withholding tax, depending on the tenure, infrastructure bonds are tax-free. Likewise, capital gains tax is charged on gains accrued from the transfer of property i.e. Buildings, land, or shares in Kenya.
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Saving and investing money is key to reaching your goals and maintaining financial security, but knowing where to put your money is equally an important skill to master. It will ensure you achieve your goals, earn your desired returns, avoid unnecessary risks, protect your money from inflation, and diversify your portfolio.
There is no one-size-fits-all approach when deciding where to put your money. Rather, your choice will depend on your circumstances, risk tolerance, time horizon, and specific financial goals. If you are struggling with where to keep your savings, consider these seven options.
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