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You’re still making this huge retirement savings mistake, aren’t you?

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Paying the bills and putting some money aside for your retirement isn’t always easy.

Unfortunately, recent government figures suggest many of us are making a costly mistake with our savings that could delay our retirement. In this article I’ll explain what the problem is and how you can fix it.

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All cashed up

I’d always suggest trying to keep a rainy day fund of between three and six months’ living costs saved in cash in case of unexpected bills. I’d also save in cash for big purchases like holidays.

But today’s low interest rates mean that saving in cash won’t really make any money for you.

I’ve recently switched my ISA to an account offering 1.5%, which was the best easy access interest rate I could find. Unfortunately, with inflation running at 2.1% at the moment, my money will still be losing value in real terms each year.

This is the mistake I mentioned earlier — 72% of ISA subscriptions last year were made to Cash ISAs. Just 26% were to Stocks and Shares ISAs. Although saving in cash makes sense for money you may need in the next few years, in my view it’s not a very effective way to save for your retirement.

There is a better way

As you might guess, I think that the stock market is a much better way to save for retirement. Although the market tends to rise and fall unpredictably over short periods, history suggests that over the long term it usually goes up.

The average return from the UK stock market has been about 8% per year over the last century, or roughly 5% after inflation.

Using an 8% annual return as an example, saving £100 per month for 20 years would leave you with a lump sum of £58,902.

Of this, just £24,000 would be the money you’d invested — the remaining £34,902 would be accumulated dividend income, or interest.

By contrast, saving £100 into a Cash ISA paying 1.5% for 20 years would leave you with just £27,968 — only £3,968 of accumulated interest.

The secret here is what’s known as ‘compounding’. This means earning interest on previously paid interest. It’s a powerful way to build wealth.

How to invest in stocks and shares

How should you put your money to work in the stock market?

The simplest option is probably to put money into a FTSE 100 tracker fund inside a Stocks and Shares ISA. This is cheap, simple and allows contributions from as little as £25 per month. The FTSE 100 offers an income yield of about 4.5% at the moment, so you’ll enjoy a decent income as well as any long-term gains in the market.

A second option is to gradually invest cash in good quality FTSE 100 dividend stocks. This gives you an opportunity to enjoy higher rates of income and growth than the market average. But it also means you’re far more exposed to company-specific problems which could leave you sitting on losses.

Whatever you choose, it’s important to invest money that you won’t need for at least five years, preferably longer.

You’ll also need to hold your nerve and keep paying in if the market falls. Selling after a market crash is usually the wrong decision. Historically, markets have always bounced back over time. In fact, buying when markets are down tends to be quite profitable over long periods.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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