How to Turn Your Savings into Wealth: A Practical Guide for Young Adults

Are you a young adult who wants to achieve financial freedom and security? Do you have some savings but don't know how to make them grow? Do you want to learn the basics of investing and how it can help you beat inflation and generate passive income?

If you answered yes to any of these questions, then this article is for you. In this article, you will learn:

• The difference between saving and investing and why you need both

• The benefits and risks of investing and how to manage them

• The types of investments that suit your goals and risk tolerance

• The steps to start investing and build a diversified portfolio

• The best practices and tips to become a successful investor

By the end of this article, you will have a clear understanding of how to transition from saving to investing and how to use your money to create wealth and achieve your financial dreams.

Saving vs Investing: What's the Difference and Why You Need Both

Saving and investing are two essential components of personal finance. They are both ways of using your money to achieve your goals, but they have different purposes and characteristics.

Saving is the act of setting aside a portion of your income for future use. It is usually done in a safe and liquid account, such as a bank account or a money market fund, that offers low or no interest. Saving is important for:

• Building an emergency fund that can cover unexpected expenses or income loss

• Saving up for short-term or specific goals, such as buying a car, a house, or a vacation

• Having a cash cushion that can help you avoid debt or pay off high-interest debt

Investing is the act of putting your money to work in assets that have the potential to increase in value over time. It is usually done in a less liquid and more risky account, such as a stock, a bond, or a mutual fund, that offers higher returns. Investing is important for:

• Growing your money faster than inflation and increasing your purchasing power

• Generating passive income from dividends, interest, or capital gains

• Building wealth and achieving long-term or general goals, such as retirement, education, or financial independence

Saving and investing are not mutually exclusive. You need both to have a balanced and healthy financial life. Saving provides you with stability and security, while investing provides you with growth and opportunity. Saving helps you prepare for investing, while investing helps you multiply your savings.

The Benefits and Risks of Investing and How to Manage Them

Investing has many benefits that can help you improve your financial situation and quality of life. Some of the benefits are:

• Higher returns: Investing can offer you higher returns than saving, especially in the long run. For example, the average annual return of the S&P 500, a benchmark index of the US stock market, was about 10% from 1926 to 2020, while the average annual inflation rate was about 3%. This means that investing in the stock market could have increased your money by 7% per year, on average, after adjusting for inflation.

• Compound interest: Investing can also benefit from the power of compound interest, which is the interest earned on both the principal and the accumulated interest. Compound interest can make your money grow exponentially over time, as long as you reinvest your earnings and avoid withdrawing your money. For example, if you invest $10,000 at a 10% annual interest rate and reinvest all the interest, you will have $25,937 in 10 years, $67,275 in 20 years, and $174,494 in 30 years.

• Passive income: Investing can also generate passive income, which is income that you receive without active involvement or work. Passive income can come from dividends, interest, or capital gains that are paid out by your investments. Passive income can supplement your active income from your job or business and help you achieve financial independence faster.

• Tax advantages: Investing can also offer you tax advantages, depending on the type and location of your investments. Some investments, such as retirement accounts, education savings plans, or health savings accounts, can offer you tax deductions, deferrals, or exemptions, which can reduce your taxable income and increase your after-tax returns. Some investments, such as municipal bonds, qualified dividends, or long-term capital gains, can also offer you lower tax rates than ordinary income, which can also boost your net returns.

However, investing also comes with risks that you need to be aware of and manage. Some of the risks are:

• Market risk: Investing exposes you to market risk, which is the risk of losing money due to fluctuations in the prices of your investments. Market risk can be caused by various factors, such as economic cycles, political events, natural disasters, or human emotions. Market risk can affect your investments in different ways, depending on the type, duration, and diversification of your investments. For example, stocks are more volatile than bonds, short-term investments are more sensitive than long-term investments, and concentrated portfolios are more risky than diversified portfolios.

• Inflation risk: Investing also exposes you to inflation risk, which is the risk of losing purchasing power due to the rise in the general level of prices. Inflation risk can erode the real value of your money and reduce your real returns. Inflation risk can affect your investments in different ways, depending on the inflation rate, the interest rate, and the growth rate of your investments. For example, cash and bonds are more vulnerable to inflation than stocks, low-interest investments are more affected than high-interest investments, and slow-growing investments are more impacted than fast-growing investments.

• Liquidity risk: Investing also exposes you to liquidity risk, which is the risk of not being able to sell your investments quickly and easily at a fair price. Liquidity risk can limit your access to your money and force you to accept a lower price or a higher cost. Liquidity risk can affect your investments in different ways, depending on the supply and demand, the transaction costs, and the regulations of your investments. For example, real estate and private equity are less liquid than stocks and bonds, high-commission investments are more costly than low-commission investments, and restricted investments are more regulated than unrestricted investments.

The best way to manage the risks of investing is to follow these principles:

• Know your risk tolerance: Your risk tolerance is the degree of uncertainty and volatility that you are willing and able to accept in your investments. Your risk tolerance depends on your personality, goals, time horizon, and financial situation. You should invest according to your risk tolerance, which means choosing investments that match your risk profile and avoiding investments that exceed your risk capacity. You can assess your risk tolerance by taking a risk questionnaire or consulting a financial planner.

• Diversify your portfolio: Diversification is the practice of spreading your money across different types of investments, such as stocks, bonds, commodities, real estate, or alternative assets. Diversification can reduce your exposure to any single source of risk and increase your chances of capturing the returns of different markets and sectors. You can diversify your portfolio by following the asset allocation model that suits your risk tolerance and goals, and by choosing investments that have low or negative correlations with each other.

• Rebalance your portfolio: Rebalancing is the practice of adjusting your portfolio periodically to maintain your desired asset allocation and risk level. Rebalancing can help you avoid drifts in your portfolio that can result from changes in the market conditions or the performance of your investments. Rebalancing can also help you take advantage of market opportunities and lock in your gains or losses. You can rebalance your portfolio by following a schedule, such as quarterly or annually, or by following a threshold, such as 5% or 10%.

The Types of Investments that Suit Your Goals and Risk Tolerance

There are many types of investments that you can choose from, depending on your goals and risk tolerance. Here are some of the most common types of investments and their characteristics:

• Stocks: Stocks are shares of ownership in a company that entitle you to a portion of its profits and assets. Stocks can offer you high returns in the form of capital appreciation and dividends, but they also expose you to high risks in the form of price volatility and company-specific issues. Stocks are suitable for investors who have a long-term horizon, a high risk tolerance, and a growth-oriented goal.

• Bonds: Bonds are loans that you make to a government or a corporation that promise to pay you a fixed amount of interest and principal at a specified date. Bonds can offer you moderate returns in the form of interest income and capital preservation, but they also expose you to moderate risks in the form of interest rate fluctuations and default risk. Bonds are suitable for investors who have a medium-term horizon, a medium risk tolerance, and an income-oriented goal.

• Cash: Cash is money that you hold in a bank account or a money market fund that offers you easy access and safety. Cash can offer you low returns in the form of interest income and liquidity, but it also exposes you to low risks in the form of inflation and opportunity cost. Cash is suitable for investors who have a short-term horizon, a low risk tolerance, and a stability-oriented goal.

• Commodities: Commodities are physical goods that are traded in the market, such as gold, oil, or wheat. Commodities can offer you variable returns in the form of price changes and hedging benefits, but they also expose you to variable risks in the form of supply and demand shocks and storage costs. Commodities are suitable for investors who have a speculative outlook, a high risk tolerance, and a diversification goal.

• Real Estate: Real estate is property that you own or invest in, such as residential, commercial, or industrial buildings, or land. Real estate can offer you stable returns in the form of rental income and capital appreciation, but it also exposes you to specific risks in the form of market fluctuations, maintenance costs, and liquidity issues. Real estate is suitable for investors who have a long-term horizon, a moderate risk tolerance, and a wealth-building goal.

• Mutual Funds: Mutual funds are investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. Mutual funds can offer you diversification and professional management, but they come with fees and potentially less control over investment choices. They are suitable for investors seeking diversification and those who prefer to leave investment decisions to professionals.

• Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds in that they offer a diversified basket of assets but are traded on stock exchanges like individual stocks. ETFs often have lower fees than mutual funds and provide flexibility and liquidity. They are suitable for investors looking for diversification, low costs, and the ease of trading.

The Steps to Start Investing and Build a Diversified Portfolio

To start your investing journey and build a diversified portfolio, follow these practical steps:

1. Set Clear Financial Goals: Identify what you're investing for, whether it's retirement, buying a home, or funding education. Clear goals will guide your investment strategy and choices.

2. Assess Your Financial Situation: Understand your current financial situation, including your income, expenses, debts, and emergency fund. Ensure you have a solid financial foundation before investing.

3. Determine Your Risk Tolerance: Evaluate how much risk you're comfortable taking on. Your risk tolerance will influence the types of investments you select and the allocation of assets in your portfolio.

4. Educate Yourself: Learn about different types of investments and how they work. Knowledge is power, and understanding the basics will help you make informed decisions.

5. Open an Investment Account: Choose a brokerage firm or robo-advisor that aligns with your needs and open an investment account. Consider fees, services offered, and ease of use when selecting a platform. Interactive Broker, for example, is known for its powerful trading platforms and low commissions and fees, making it an attractive option for younger investors or those just starting out.

6. Start Small and Diversify: Begin with an amount you're comfortable with and gradually increase your investment over time. Ensure your portfolio is diversified across different asset classes to spread risk.

7. Monitor and Adjust Your Portfolio: Regularly review your investments and their performance. Be prepared to rebalance your portfolio to maintain your desired asset allocation and adapt to changes in your financial goals or market conditions.

Best Practices and Tips to Become a Successful Investor

• Start Early: The sooner you start investing, the more time your money has to grow through the power of compounding.

• Invest Regularly: Consider a strategy of regular, consistent investments, such as dollar-cost averaging, to reduce the impact of market volatility.

• Stay Informed: Keep up with financial news and market trends, but avoid making impulsive decisions based on short-term market movements.

• Avoid High Fees: High investment fees can eat into your returns. Look for low-cost investment options and be mindful of the fees you're paying.

• Be Patient: Investing is a long-term endeavor. Avoid the temptation to chase quick profits and be prepared for ups and downs in the market.

• Seek Professional Advice: If you're unsure about your investment decisions, consider consulting a financial advisor for personalized guidance.

By following the steps outlined in this guide and adopting these best practices, young adults can confidently transition from saving to investing. This transition is key to building wealth, beating inflation, and achieving financial freedom. Remember, investing is not without risks, but with careful planning, education, and a long-term perspective, it's a powerful tool for financial growth. Welcome to the world of investing—your journey to financial empowerment starts now.