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Put Your Savings to Work

You've budgeted and identified an amount to save monthly. Where are you going to put your savings? Investing is putting the money you save to work, increasing your wealth.

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In this lesson, you'll learn about:

  • Investments.
  • The magic of compound interest.
  • Risk vs. return.

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Get Guidance

There's an art to choosing ways to invest your savings. Good investments will make money; bad investments will cost money.

Do your homework. Gather information and seek advice from licensed or registered advisers.

Also, check out the resources section in the Building Wealth app for helpful sites.

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Compound Interest

Compound interest is interest paid on previously earned interest as well as on the original deposit or investment.

For example, if Lynne's investment earns a 6% average annual rate of return, her $125 per month deposit will grow to $8,000 after 5 years.

Let's see how interest compounds on Lynne's savings. Assume she saves $125 a month for 30 years and her interest is compounded monthly.

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After 5 years of $125 monthly deposits...

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And after 15 years of deposits and compounding interest...

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As you can see, compounding interest on investments has a greater effect over time.

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The charts on the previous pages show how compound interest at various rates would increase Lynne's savings compared with simply putting the money in a shoebox. This is compound interest that you earn.

As you can see from Lynne's investment, compounding has a greater effect after the investment and interest have increased over a longer period.

Now let's learn the concept of risk-expected return.

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Understand the Risk/Expected Return Relationship

When saving and investing, the amount of expected return is based on the amount of risk. Generally, the higher the expected return, the higher the risk of losing money.

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For example, a basic savings account is insured by the Federal Deposit Insurance Corp. (FDIC) up to $250,000.

The return — or interest paid on your savings — will be less than the expected return on other types of investments.

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On the other hand, an investment in a stock or bond is not insured.

The money you invest may be lost or the value reduced if the investment doesn't perform as expected.

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How Much Risk Do You Want to Take?

Here are some things to think about to determine the amount of risk you are willing to take:

  • Your financial goals.
  • Your time horizon.
  • Your financial risk tolerance.
  • The inflation risk of the investment.
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Financial Goals

How much money do you want to accumulate over a certain period of time? Your investment decisions should reflect your wealth-creation goals.

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Time Horizon

How long can you leave your money invested? If you will need your money in one year, you may want to take less risk than you would if you won't need your money for 20 years.

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Financial Risk Tolerance

Are you in a financial position to invest in riskier alternatives? You should take less risk if you cannot afford to lose your investment or have its value fall.

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Inflation Risk

This reflects savings' and investments' sensitivity to the inflation rate. While some investments such as a savings account have no risk of default, there is the risk that inflation will rise above the interest rate on the account.

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After deciding how much risk you are able to take, consider the investment pyramid to help balance your savings and investments.


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Lessons Learned

Now that you know more about compound interest and risk, you can begin to consider which types of investments are best for you. Remember, do your homework and get guidance from a licensed adviser.