Saving and investing are two essential investing strategies to reach your financial goals. But when should you save, and when should you invest?
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.
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 can make a profit from investing in one of two ways:
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.
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 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.
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 you’re investing than when you’re 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 would’ve invested $1 into a saving account with 1% interest instead you would’ve ended up with just $1.10 after 10 years.
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.
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:
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.
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 don’t turn out as planned.
If the following conditions are met you should save rather than invest:
If however the following conditions are met you should invest your money instead of saving it:
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.