How to Save and Invest Money Wisely

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At its core, investing money wisely comes down to a handful of behaviors that work together to build wealth. Build enough wealth and you'll achieve financial independence—when your investments produce enough passive income to cover your living expenses without you needing a job.

Since everyone's lifestyle goals are different, this means that the finish line for every investor is different, too. Whether you want just enough for a simple cabin and a trusty dog, or an oceanside villa and flashy cars, your investment strategy needs to follow a few key rules to maximize its potential.

Understand Your Investments

If there is one rule that saves both money and trouble, it's this: Don't buy or hold any investment you don't understand. You should know how it makes its money, what its pitfalls are, and how that money finds its way into your hands.

Can you explain what a collateralized debt obligation is? If not, don't buy it. Do you know the difference between a share of stock and a master limited partnership (MLP) unit? No? Then don't buy MLPs. You could be in for an unpleasant tax surprise if you start collecting them without knowing what you're doing.

The same goes for everything from convertible shares to REITs. Jumping in before you are well-informed and aware of the dangers puts your money at risk.

Proactively Manage Risk

Risk is ever-present when managing your money, and investing wisely requires you to reduce it. If you don't, you could wipe out years, even a lifetime, of savings.

There are many types of investment riskliquidity risk, inflation risk, market risk, counterparty risk, and fraud risk. One of the reasons it is so important to focus not on absolute returns but rather on risk-adjusted returns is so that you take risk into account.

For most investors, the most successful way to drastically reduce risks of all kinds is to use dollar-cost averaging, diversified portfolios, and long-term investments. Dollar-cost averaging means you spread out the purchase of an asset over a span of time, offsetting any price fluctuations. Diversify your assets to include stocksbonds, commodities, mutual funds, and real estate. Then hold your investments for the long-term, which will offset any short-term losses with long-term gains.

Couple this strategy with large cash reserves and you create a sizable cushion in the event of a job loss, recession, stock market collapse, natural disaster, or other unexpected situation. Keeping some of your assets liquid also allows you to buy assets on the cheap when the opportunity arises.

Perhaps nobody embodies this concept better than billionaire investor Warren Buffett. His holding company, Berkshire Hathaway, had a record $122 billion in cash and cash equivalents on the balance sheet in June 2019. He piles up money, sometimes for years on end, waiting for the right time to pick up incredible deals. You can do the same.

Take Advantage of Compound Interest

Wise investing means harnessing the power of compound interest. Compound interest accrues on your interest as well as your principal. It accelerates your money's growth exponentially over time. The younger you start, the greater its effect on your net worth. 

To illustrate the concept, imagine three investors: Daisy, Abigail, and Samuel.

Daisy's parents invest $100 a month in her account every year from her birth until Daisy turns 18, at which point she takes over, continuing the same rate of $100 per month until age 65. Assuming an average rate of return of 10%, she ends up with $6,149,231 before taxes at age 65.

Abigail doesn't start investing until age 18 and invests $400 a month. Assuming the same average rate of return of 10%, she ends up with $4,382,833 before taxes by age 65.

Samuel doesn't start investing until age 45, at which point he invests $5,000 a month. Assuming an average rate of return of 10%, he ends up with $3,624,934 before taxes by age 65.

Despite Samuel investing 50 times as much per month as Daisy, Daisy ended up with almost twice the money he did because she invested longer. That's the power of compound interest.

Minimize Taxes

The more you save on taxes, the more money you have available to invest and earn compound interest. There are several ways to minimize your tax liability, including deferring it by managing your portfolio to control the difference between when the tax is accrued and when it is paid.

You can minimize your tax liability by using a Roth IRA. Your family can structure its holdings to take advantage of the stepped-up basis loophole upon death, protecting heirs from capital gains taxes. Utilize the asset placement technique, which strategically locates your assets to minimize tax payments. Or you can form family limited partnerships to transfer wealth and lower gift and estate taxes.

To take advantage of any breaks Congress has given you under the law, speak with your advisors to find out what you're missing.

Control Your Expenses

Another aspect of investing wisely is controlling your fees and expenses.

Sometimes, fees can be worth the cost. For certain high-net-worth people with complex needs, a registered investment advisor charging a 2% fee can absolutely be worth his weight in gold. Someone structuring a portfolio using a charitable remainder trust or another setup would be well-served by paying a professional to assist.

But for most small- and medium-sized investors, cost matters. You can reduce expenses by choosing something like a low-cost, passively managed index fund from a firm like Vanguard, or by paying close attention to the expense ratio of a chosen mutual fund. You may consider switching to a discount brokerage to save on trade fees, or you might use a robo-advisor to manage your investments instead of an expensive financial advisor.

Investing wisely is key to growing your net worth, and you can get there with careful attention. Cultivating the financial habits above allow you to minimize costs, maximize returns, and proactively manage your investments as your financial future takes shape.