Saving vs. Investing: Should You Invest For Short-Term Goals?
Saving and investing are two essential investing strategies to reach your financial goals. But when should you save, and when should you invest?
In this chapter, weâll take a look at:
Saving and investing are two main strategies that you can use to gain financial security. Both can be useful to achieve your short-term and long-term financial goals. However, they differ in their overall objectives, level of risk, and time horizon.
Understanding the key differences is an important part when learning about the basics of investing. You should make sure that you understand the distinction between saving investing before you start to plan your financial strategy.
In this chapter, you will learn about the differences between saving and investing, how to choose between them and how to set your financial goals.
đ§ Key Takeaways
- Saving works best for short-term financial goals. You should also save when you need your money back on a specific date.
- Contrary, investing works better for long-term financial goals. You should also invest if you aim to grow your money and compound its value.
What Is Saving?
When you save you regularly put some of your money aside in order to access it at a later date. Usually, you will save for a specific short-term savings goal, such as vacation or a new smartphone.
You will typically keep your savings in a safe space, such as a savings account. As a result, your savings will be highly liquid and, therefore, can be easily and quickly accessed if needed. In addition, the value of your savings will not be affected by short-term market fluctuations and the growth prospects of other, riskier assets. Instead, the value of your savings will only be affected by the paid-out interest and the effect of inflation. Therefore, saving is generally considered to be safer than investing.
The downside is that you cannot expect a significant return on your savings. Most savings accounts will pay you a low interest rate on your savings, while some might not pay any interest at all.
Therefore, your savings can only increase in value for two reasons:
- You add more funds to your savings.
- You receive interest payments on your savings.
What Is Investing?
When you invest you purchase assets, such as stocks, bonds, or exchange-traded funds (ETFs), in order to make a profit in the future. Investors invest their money with a long-term time horizon.
You can make a profit from investing in one of two ways:
- You can sell the investment at a higher price than you bought it.
- You receive paid-out income from your investments in the form of dividends or interest.
Unlike your savings, your investments can not just increase but also decrease in value depending on the characteristics and risk of the investment. For example, a company whose stock you own might experience falling sales that result in a decrease in the value of the stock.
Many investments have to be first converted back into money after selling them. As a result, it can take much longer before you can access the value of your investment. Some investments, like stocks, may take just a few days to sell. Contrary, other investments, like private equity or real estate, may take months or even years.
What Is The Difference Between Saving And Investing?
The words saving and investing are often used interchangeably. Both require you to delay spending some of your money in order to achieve a financial goal in the future.
However, they are entirely different financial concepts with different purposes in your financial strategy. Saving can be used to have enough cash for your short-term goals. Investing, on the other hand, can be used to build up wealth in the long term.
Saving and investing differ on a few key points:
- The level of risk and losing your money.
- The possible return on your savings or investment.
- The liquidity of your assets.
- The time horizon of your objectives.
Risks
The biggest difference between saving and investing is the level of risk you take.
Saving your money is almost risk-free as you typically put your savings into a dedicated savings account with guaranteed returns. A bank will typically pay you a small but reliable interest on your savings. In addition, most banks in the European Union, United Kingdom, and the United States insure your savings up to a certain amount. This means that your savings are safe and protected in the unlikely event that your bank goes insolvent.
Investing gives you the opportunity to earn a higher return but at the expense of higher risk. The risk is usually linked to the return and therefore investments with a higher return tend to be riskier. In extreme cases a total loss of your investment is possible. To prevent this you should set up a well-diversified portfolio. In addition, you should always make sure that you understand the investment you make.
Possible Return
Both saving and investing benefit from the power of compounding. This means that your money grows exponentially the longer it compounds. However, the possible growth rates are much higher when youâre investing than when youâre saving.
For example, the S&P 500 is a market index that tracks the performance of the 500 biggest USA-listed companies. It achieved an average annual return of 14% between 2010 and 2020. As a result, if you invested $1 into companies that are included in the S&P 500 in 2010 it would now be worth $4.22.
Contrast this with most savings accounts which offer much lower interest rates. For example, if you wouldâve invested $1 into a saving account with 1% interest instead you wouldâve ended up with just $1.10 after 10 years.
Liquidity
One major difference between savings and investments is how easily you can access the value of your savings or investments.
Your savings are generally very easy to access at any time. As they are stored in a savings account you don't have to convert them into cash in order to access them.
Investments on the other hand are much harder to convert back into cash. Stocks, exchange-traded funds, and bonds are generally easy to convert into cash. This is because they are generally being traded at a high frequency. However other investments, like private equity or real estate take a lot longer to turn back into cash. In the worst case, it can take up to multiple years to sell these assets.
Time Horizon
The last differentiating factor between saving and investing is your time horizon. As we will learn in an upcoming chapter, it doesn't make sense to keep your cash in a savings account for longer periods of time. As a result of the time value of money, you would miss out on the effect of compounding your money at a reasonable growth rate because the possible rate of return is much higher with most other types of investments.
Therefore you should only prefer saving over investing in the following cases:
- You expect to need your money back in the near future.
- You cannot tolerate a potential loss of your invested capital.
What Are The Pros And Cons Of Investing vs. Saving
Both saving and investing can be helpful investing strategies to reach your financial goals. However, it is important that you know the benefits and drawbacks of both strategies.
Saving
đ Benefits
- You know upfront how much interest will be paid to you on your balance and your expected return.
- Your savings are typically insured if you keep them in a bank or savings account.
- It is very easy to access your savings in case you need the money back quickly.
- There is no learning curve to start saving.
đ Drawbacks
- You will only earn a small return on your savings. Some banks may not even pay you interest at all.
- Because your returns will often be below the rate of inflation your purchasing power will decrease as the value of your money declines.
Investing
đ Benefits
- Most types of investments provide higher returns than a savings account.
- As most investment types offer higher returns your purchasing power is not impacted. Therefore you are less affected by the effects of inflation.
đ Drawbacks
- A total loss of your investments is possible.
- While higher returns are possible they are not being guaranteed.
- The liquidity of investments varies based on the different types of assets.
- Most types of investments have a high learning curve.
How Do I Decide Between Saving And Investing?
It can be hard to decide whether you should save or invest for a specific financial goal. You should consider your risk tolerance, time horizon, and expected return when deciding between saving and investing. However, the key factor is whether you are able to delay your financial goal if things donât turn out as planned.
If the following conditions are met you should save rather than invest:
- You need the money back by a certain date.
- You expect to need the money within the next year.
- You are fine with receiving little or no return in favor of less risk of losing your money.
- You are not able to delay your goal if things donât turn out as planned.
If however the following conditions are met you should invest your money instead of saving it:
- You donât have a fixed date by which you need your money back.
- You want to generate a positive return with your money.
- You are able to delay your goal if things donât turn out as planned.
- You want to outpace inflation and retain the value of your money.
Next Chapter
Continue with the next lesson of our beginner-friendly guide âBasics Of Investingâ.