During a conversation with a friend the other day, she mentioned that she has two types of money: frivolity fund and serious savings. The excess money she earns every month is her frivolity fund, to be spent on things that she likes the look of, once the important things like her mortgage and food shopping have been paid. The cash in her savings though, is serious savings; it’s there for a purpose and it can’t be spent on expensive frivolities, no matter how badly she wants them. Her main problem is that she doesn’t really know what her serious savings are for.
It’s certainly the case that some of us are more inclined to frivolous spending than to serious saving. I also see those who have large monthly incomes and no savings at all, because they enjoy spending money on the things that they want. (For the purposes of full disclosure, I admit to being more frivolous spender than serious saver. I know that I should save so I put something aside each month, but I’m more inclined to spend excess cash than save it because I like the instant gratification of buying nice things.)
It’s also not unusual to find people who have savings but no purpose for them. I meet clients who have amassed large amounts of cash on very little income simply because it’s in their nature to be prudent with money and save wherever possible.
Whatever your attitude to savings, there are better ways to save than others. We don’t offer advice on cash savings because there’s no real skill in finding the best interest rates, so savers are unwilling to pay for such advice. But cash savings form part of the wider financial plan and there are a few basic things that we advise whether you’re a serious saver or a frivolous spender:
Establish an emergency fund. We usually advise on cash savings to the value of 3 months of earnings. This fund isn’t necessarily to cover worst case scenario, although it would probably come in pretty useful if you needed to replace your car or fix a hole in your roof. It could also be used to fund a once in a lifetime opportunity. So if an emergency fund sounds a little bit too serious, you could think of it as your running away fund.
Save for short-term goals. If you can get beyond the emergency fund savings stage, it’s a good idea to think about the things that you want to buy in the short-term, say within the next five years. This could be a new car, a holiday or wedding. These savings should be kept in cash to avoid the risk of a fall in value before they’re required. It’s a good idea to shop around for the best interest rates and move your money when introductory offers end and interest rates fall.
Understand the effects of inflation. Interest rates are important because they represent the return that your cash is giving you. However, inflation is just as important because it erodes the real value of your cash savings. Cash is often perceived to be risk free, but it usually loses its real purchasing power when the rate of inflation is higher than interest rates. Where this is the case – as it has been for the past few years – you should limit the amount you hold in cash wherever possible.
Don’t tie your money into an account for too long. You can often find better rates on cash if you lock your money in for a set period of time in a term deposit account. While the rates of interest on these accounts are often higher than on standard deposit accounts, you need to consider the risk of interest rates rising while your money is locked in. If you select a 3-year term and interest rates rise significantly in the first 2 years, you could find that you’ve earned less interest than if you had kept your cash in an instant access account.
Save for long-term goals. We advise anyone with long-term goals such as funding a child’s education or retirement to use investments rather than cash. This avoids the risk of inflation eroding the value of your savings because investments produce two returns in the form of capital growth & income (cash only produces income in the form of interest). It’s the capital growth of investments that allow them to produce superior returns over the long-term. Of course, it’s important to understand that by investing cash savings you replace inflation risk with investment risk. i.e. the risk that your investments will fall in value at a greater rate than cash. This is why investments should be probably managed to ensure the risk of this happening shortly before you want to access them is minimised.
I’d advise frivolous spenders (myself included) that saving is a habit, the more you manage to put aside, the easier it becomes. And I’d encourage serious savers to ask themselves what they’re saving for, and if some of their cash wouldn’t be better invested in funds.