FP - Saving, Investing, and Opportunity Cost Lesson

Saving, Investing, and Opportunity Cost

Before we consider savings and investing vehicles, let's review and lay some groundwork. We know that the savings and/or investment vehicles we choose depend on our time frame and our risk tolerance. Even within those parameters, we will have lots of choices to make. The economic decision-making model suggests that we decide on the criteria our vehicle must meet and rate each vehicle on those criteria. One other element of our decision (and any decision, for that matter) is opportunity cost. Opportunity cost is the cost of giving up the next best alternative.

Opportunity cost may not have a monetary value, but rather it might be valued in time or even enjoyment. Here is an example. Suppose you have received $1000 for your 18th birthday. You can add that money to your college savings or you can use it to take a once-in-a-lifetime trip. If you choose to put your money in savings, the opportunity cost would be the experience and fun of taking the trip (not the cost of the trip). If you choose the trip, the opportunity cost would be the satisfaction of having that extra cushion to cover college costs and possibly the interest that $1,000 would have earned. Every decision we make has those kinds of tradeoffs and we are cheating ourselves if we don't consider them in the decision-making process.

Time Frames and Investment Choices

Previously, we talked about short-term, intermediate-term, and long-term goals. A good rule of thumb for choosing savings or investing is this:

  • If you will use the money in less than 5 years - save.
  • If you will need the money more than 10 years in the future - invest.
  • If you need the money between 5 and 10 years in the future, a combination of saving and investing would be in order. This combination should be directed by your goal, your risk tolerance, and your financial situation.

Savings Instruments

Review the presentation below to learn about the risk and return associated with different savings opportunities.

A few words about Savings Bonds

There are two types of savings bonds: Series EE and Series I. Savings bonds are issued by the Federal government. Both Series EE and Series I bonds pay an amount of interest that is stated at purchase and both must be held for at least five years to be redeemed without penalty. The main difference between the two bonds is how their interest is calculated. Series EE bonds earn a fixed rate of interest as stated at the time of purchase. Series I bonds also earn a fixed rate of interest as stated when purchased, but also earn additional interest based on inflation.

Investment Instruments

In previous modules, we have discussed the differences in risk and return between stocks and bonds and we have discovered that mutual funds can be a combination of all of these. While purchasing an individual stock or even bonds may be beyond the means of many of us as we begin investing, mutual funds are not. Outside of IRAs or other retirement savings plans, the minimum deposits in a mutual fund could be as little as $1,000. Within the retirement savings plans, they are even less. Before we investigate the risk and return of different types of mutual funds, let's look at some of these plans, including one that is not for retirement.

Investment Plans: 401k and 403b Plans – These plans are named after the U.S. legal code that created them. 401k refers to retirement plans for companies in the private sector, while a 403b refers to those employed in the public sector. The laws that allowed these plans to exist set forth the rules on contributions, withdrawals, and taxation that affect each plan. These plans may be instead of pensions or to augment them. Traditional and ROTH IRAs – These are individual retirement plans for those who are not covered by an employer's plan or in addition to an employer's plan. Like 401k and 403b plans the government has set specific rules on the amount of contributions, withdrawals, and taxation of these plans. 529 Plans: These plans are similar in structure to the previous four retirement plans, but they are meant for saving for college. If the earnings of these plans are not used to pay qualified college expenses, then those earnings can be taxed as income.

A few of the highlights of all of these plans include:

  • Earnings in the funds grow tax free.
  • There are tax penalties for early withdrawal.
  • Except for a Roth IRA, annual contributions are tax deductible.
  • Funds are not taxed until the money is withdrawn. Withdrawals from a Roth IRA are not taxed.

Types of Mutual Funds

Remember that mutual funds are professionally managed investment instruments that take money from many small investors and invests in a variety of stocks and bonds. In turn, each investor owns a proportionate amount of the fund value. One of the benefits of mutual funds is their ability to supply diversification in investments. Inside and outside of retirement and savings plans like those we just reviewed, investors can choose from many types of funds and may choose to invest in several funds to further diversify their holdings. Also, holding more than one mutual fund may help an investor meet short-term, intermediate-term, and long-term goals. The tabbed presentation below will help you understand some of the broad categories of mutual funds.

Self-Assessment

Check your understanding by answering the questions below. Roll your mouse over each question to check your answer.

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