Too often, personal finance beginners ask whether they should have a savings account or investments. The implication is that they believe saving and investing are one and the same and that it is simply a matter of picking the “right one for them.” Yet to think this way is to confuse two wholly different things. In reality, it is not an either-or question. Saving and investing are distinct from one another, and each has its place in the financial lives of most responsible adults.
Risk & Reward
The fundamental difference between savings and investments lies in the risks and rewards involved. Generally speaking, your money is safer in a bank savings account than in the stock market. If the bank fails, Federal Deposit Insurance covers up to $200,000 of your savings deposits. As personal finance author Ramit Sethi writes in his book I Will Teach You to be Rich, “politicians will move heaven and earth to protect the savings of ordinary Americans.” That said, the relative safety of keeping money in savings is reflected in your returns. Today, most banks pay less than 1% interest on savings deposits. It is considered outstanding to receive more than 1.5%. Investments are riskier, because there is always the possibility of the company you invested in going under. There can also be a market-wide crash, like that which occurred in late 2008. Consequently, stocks and bonds must pay higher rates of return – sometimes in excess of 10% or more – to compensate for the greater risks inherent in investing.
To recap: the main purpose of savings is security, while the main purpose of investing is growth.
What Savings Is Best For
The risks and rewards of savings vs. investment suggests that each activity is suited for different things. Savings, in particular, is ideally used for money that you could need rapid access to. Most personal finance experts suggest, for instance, that you keep an “emergency fund” containing three to six months worth of living expenses. It would make little sense to keep such funds tied up in investments, because it can take several days to recover money from the market. Furthermore, if your investments have appreciated, you will owe capital gains tax as soon as the money is withdrawn. It is also unlikely that you will want to remove investment capital at the precise moment that your stocks are appreciating. Savings, on the other hand, can be accessed from any bank or ATM machine using a debit card. In the worst case scenario, you will need to wait until the next business day and withdraw the needed amount in person, at a branch. Savings accounts are also well-adapted to short or medium-term savings goals, including new car down payments, a wardrobe or an upcoming semester of college tuition.
As a general rule, money you anticipate needing in the next two to five years should be in a bank savings account, rather than the stock market.
What Investing Is Best For
Investing, on the other hand, is better suited for wealth accumulation aimed at the distant future. Retirement savings is a prime example. Because you do not anticipate withdrawing your retirement savings for many years (perhaps even decades), you ought to take advantage of the superior growth opportunities offered by the stock market. Your extended time horizon counteracts the greater risks involved, because you can afford to be patient and ride out a downturn. The same applies to any financial goal whose realization is many years off. If you are currently twenty years old and want to start a business when you turn forty, this is another excellent investment opportunity. By steadily investing over the next ten or fifteen years, you could potentially exit the stock market with substantially more money than you put in.
As discussed earlier, the stock market is best suited for money that will not be needed for two to five years. This applies even to your retirement savings. Once you near retirement age, your investment capital should generally be reallocated to bonds or savings, where it is relatively safer and more readily liquidated for spending. Investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.
Both Should be Automated
Personal finance beginners tend to believe that effective saving and investing is about hard work. People who amass small fortunes, they believe, are simply more committed, mature or focused than themselves. In fact, this is rarely true of most financially successful individuals. More often than not, those who manage to make their money work for them have mastered the art of automation. In recognition of their weaknesses (be it laziness, forgetfulness, procrastination or excuse-making), they establish systems that save and invest without any manual involvement. Most banks, for instance, offer automatic savings plans that will transfer a set amount from checking to savings at scheduled intervals. You can set this up to occur monthly or bi-weekly, depending on how often you are paid. Brokerage accounts have similar capabilities, like automatic, scheduled contributions to your IRA.
In either case, you are unlikely to make much headway with either saving or investing if you do them manually. Only once you have used automation to remove yourself from the process can these two vitally important (and different) activities truly contribute to your financial security.
About the Author: Chris Bennett is a marketing director for Creditloan.com. Credit Loan has been in the business of helping people with money problems for over twelve years. The site provides one-stop access to intuitive articles, reputable service providers and financial calculators. For example, loans come in so many varieties.