Often referred to interchangeably, saving and investing are not one and the same. Though they share the common denominator of prioritizing future goals over current consumption, each should occupy their own unique place in your personal finances. So, how should you strike the right balance between savings and investing?
Long-term financial planning is a fundamental component of every budgeting system. While savings and investing share some essential similarities, there are important differences between the two.
What Are Savings?
At its most basic level, savings consist of the left-over money in your bank accounts at the end of the month. However, savings are more significant than simply the money that you are not spending.
For most individuals, savings are devoted to helping you to meet your short-term needs. There are a couple of different parts of this equation.
Savings are generally kept in a bank account or perhaps a Certificate of Deposit (CD), with a locked-in and guaranteed interest rate. Savings can therefore be considered a mostly risk-free location to park your money, one that is detached from market volatility and price swings.
In addition, savings should be fairly easy to access. In other words, the money in your savings accounts is relatively liquid, and you can withdraw it quickly should a need arise. The cost of this certainty and liquidity is that your rater of return is lower than what you could conceivably obtain if you had invested these monies in the market.
For this reason, an emergency fund should probably be in a savings account that you can access relatively quickly. That being said, it is not a bad idea to make it difficult to do so–i.e. by keeping it in a CD–in order to ensure that you only take this money out for an actual emergency.
What Are Investments?
The art of investing is placing your money into assets, which you believe have the potential of increasing over time. An asset could be an equity, mutual fund, retirement account, or another type of alternative asset.
Historically, the U.S. stock market returns have far outpaced the earnings from savings accounts, leading to greater gains and the accumulation of wealth over time. However, there is one key caveat, which is repeated ad nauseum: past performance is no guarantee of future returns. Therefore, an investment is a calculated risk, one that may or may not gain in value.
Over short periods of time–sometimes stretching into multiple years–your investments may actually decrease in value. For this reason, investments should be for pursuits with longer term horizons, ones which are geared towards goals farther along the road of life.
Not all investments are created equally when it comes to liquidity, either. Individual stocks are generally relatively easy to buy and sell (minus any broker fees). However, you can be penalized for removing funds from a retirement account, making it more difficult to access these monies. In addition, alternative assets such as real estate can be highly illiquid, and require significant time and effort to turn back into cash.
How to Decide Between Savings and Investing
There are two big considerations to understand when deciding what percentage of your funds you should devote to savings and investments: (1) your timeframe and (2) your comfort level with risk.
(1) Your timeframe: Understanding the timeframe of your future needs can help you to design your savings and investing strategy.
Over short periods the market could drop, and the principal you will have invested will decrease in value. On the other hand, over longer periods of time, the market has provided returns that have far outpaced what could have been earned in a savings account.
For this reason, especially if you are early in your working years, it would make the most sense invest monies that you will use during your retirement years. On the flip side, the money you intend to use for a down payment on a house in the coming twelve months should be placed in a savings account–one that you can immediately access should an opportunity present itself.
(2) Your comfort level with risk: There is an inherent trade-off between risk versus reward. The greater the potential reward, the bigger the risk you are taking.
Investments–by definition–have a certain amount of risk, which varies by the type of investment. There is no assurance that the money you have invested will gain value, which is the reason that potential returns are higher than the guaranteed rates of savings accounts.
Savings accounts allow you to lock-in a rate of return, which will shield from the risk that your money will lose in nominal value. Those who are more conservative in nature–or very close to entering retirement–would therefore likely prefer to keep more of their monies in savings accounts than in investments.
However, if you only keep your money in savings accounts, it could still go down in actual value because of inflation. During periods of high inflation and/or low interest rates, an economy-wide rise in prices could make the purchasing power of your money decrease, even if the nominal value is increasing. In other words, if you keep all of your money in savings accounts, you run the risk of being outflanked by inflation.
Conclusion: Understanding Your Future Spending
Consumption in the present day comes at the expense of monies that will be available in the future. Whether your are placing these funds in savings accounts or investment vehicles should depend mostly on your expected timeframes, and what you plan on using your money to purchase.
Like most personal finance-related questions, the crux of the matter comes down to your future spending choices. Understanding the difference between savings and investments can help you to determine how to best channel your money into both of these important buckets of funds.
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