Saving and investing are both important, but they’re not the same thing. While both can help you achieve a more comfortable financial future, consumers need to know the differences and when it’s best to save and when it’s best to invest.
The biggest difference between saving and investing is the risk versus the reward. Saving typically allows you to earn a lower return but with virtually no risk. In contrast, investing allows you to earn a higher return, but you take on the risk of loss in order to do so.
Here are the key differences between the two – and why you need both of these strategies to help build wealth.
Savings vs Investing Explained
Saving is the act of putting away money for a future expense or need. When you choose to save money, you want to have the cash available relatively quickly, perhaps to use immediately. However, saving can be used for long-term goals as well, especially when you want to be sure you have the money at the right time in the future.
Savers typically deposit money in a low-risk bank account. Those looking to maximize their earnings from a bank account should opt for the highest annual percentage yield (APY) savings account that aligns with the minimum balance requirement best suiting them.
Investing is similar to saving in that you’re putting away money for the future, but you’re looking to achieve a higher return in exchange for taking on more risk. Typical investments include stocks, bonds, mutual funds and exchange-traded funds, or ETFs, and investors use a brokerage account to buy and sell them.
If you’re looking to invest money, you should be able to keep your funds in the investment for at least three to five years. Investments can be very volatile over short periods of time, and you can even lose money on them. So, it’s important that you only invest money that you won’t need immediately, especially within a year or two.
The table below summarizes some of the key differences between saving and investing:
|Return||Relatively low||Potentially higher or lower|
|Risk||Virtually none on FDIC-insured accounts||A lot, with the possibility of losing your entire investment|
|Typical products||Savings accounts, CDs, money-market accounts||Stocks, bonds, mutual funds and ETFs|
|Time horizon||Short||Long, 3-5 years or more|
|Protection against inflation||Only a little||Potentially a lot|
|Liquidity||High, unless CDs||High|
How are saving and investment similar?
As you can see in the table above, saving and investing have many different features, but they do share one common goal: they’re both strategies to accumulate money.
“First and foremost, both involve putting money away for future reasons,” says Chris Hogan, financial expert with Ramsey Solutions and author of Retire Inspired.
Both use specialized accounts with a financial institution to accumulate money. For savers, that means opening an account at a bank or credit union, such as Citibank. For investors, that means opening an account with an independent broker, though now many banks have a brokerage arm, too.
Savers and investors both also realize the importance of having money saved. Investors should have enough in a bank account that allows them to tie up some of their money in long-term investments.
Investing is money that you’re planning to leave alone, “to allow it to grow for your dreams and your future,” Hogan says.
Like savers, smart investors realize the value of having saved money. When they’ve got this money saved, then they can start thinking about investing.
How are saving and investing different?
“When you use the words saving and investing, people, really 90-some percent of people, think it’s exactly the same thing,” says Dan Keady, CFP, chief financial planning strategist at TIAA, a financial services organization.
While they share a few similarities, saving and investing are different in most respects. And that begins with the type of assets in each account.
When you think of saving, think of bank products such as savings accounts, money markets and CDs. And when you think of investing, think of stocks, ETFs and mutual funds, says Keady.
The benefits of saving include the following:
- Bank products such as savings accounts tell you upfront how much the account is paying, even if that amount does vary.
- While the returns are lower, you’re not likely to lose any money, because the FDIC guarantees bank accounts up to $250,000. So you’re going to get your return.
- Bank products are generally very liquid, meaning you can get your money when you need it, though you may incur a penalty if you want to access a CD.
- Fees – such as maintenance fees or Regulation D violation fees when more than six certain transactions are made out of a savings account – are the only way a savings account at a Federal Deposit Insurance Corp. (FDIC) bank can lose value.
- Saving is generally straightforward and easy to do, without a lot of costs.
However, saving does have some drawbacks:
- Returns are low, meaning you could earn more by investing (but that’s no guarantee you will.)
- Because returns are low, you may lose purchasing power over time, as inflation eats away at your money.
On the other hand, investing provides other advantages over saving – such as the potential for higher return – at the cost of new risks.
The benefits of investing include the following:
- Investing products such as stocks can have much higher returns, but you won’t know how much you’ll gain or lose in any given time period. Over time, the Standard & Poor’s 500 stock index (S&P 500), has returned about 10 percent annually, but it may fluctuate greatly in any year.
- Investing products can be very liquid, with stocks, bonds and funds being easily convertible into cash on almost any weekday. However, this does not guarantee you’ll get back the money you put into them.
- If you own a broadly diversified collection of stocks, then you’re likely to easily beat inflation over time and increase your purchasing power. Currently, the target inflation rate that the Federal Reserve uses is 2 percent. If your return is below the inflation rate, you’re losing purchasing power over time.
While there’s the potential for higher returns, investing has quite a few drawbacks:
- Returns are not guaranteed, and there’s a good chance you will lose money at least in the short term as the value of your assets fluctuates.
- You’ll want to let your money stay in an investment account for at least three years, so that you can ride out any short-term downdrafts. In general, you’ll want to hold your investments as long as possible, and that means not accessing them.
- Because investing can be complex, you’ll probably need some expert help doing it, unless you want to teach yourself how.
- Fees can be higher in brokerage accounts. You’ll often have to pay to trade a stock or fund, though some brokers offer free trades. And you may need to pay an expert to manage your money.
So which is better – saving or investing?
Neither saving or investing is better in all circumstances, and the right choice depends on the consumer’s current financial position. But here are two rules of thumb:
- If you need the money within a year or so, or you need it for any kind of emergency fund, the money should be saved.
- If you don’t need the money for the next three years or more and can withstand a complete loss, then you can invest the money.
Real-life examples are the best way to illustrate this, Keady says. For example, paying your child’s college tuition in a few months should be in savings – a savings account, money market account or a short-term CD (or a CD that’s about to mature when it’s needed).
“Otherwise people will think, ‘Well, you know, I have a year and I’m buying a house or something, maybe I should invest in the stock market,” Keady says. “That’s really gambling at that point, as opposed to investing.”
And it’s the same for an emergency fund, which should never be invested but rather kept in savings.
“So if you have an illness, a job loss or whatever, you don’t have to resort back to debt – you’ve got money you’ve intentionally set aside to be a cushion between you and life,” Hogan says.
And when is investing best?
Investing is better for longer-term money – money you are trying to grow more aggressively. Depending on your risk tolerance, investing in the stock market, exchange-traded funds or mutual funds may be an option for someone looking to invest.
When you are able to keep your money in investments longer, you give yourself more time to ride out the ups and downs of the market. So, investing is an excellent choice when you have a long time horizon – years – and won’t need to access the money in a brokerage account.
“So if someone’s beginning with investing, I would encourage them to really look at growth-stock mutual funds as a great starter way to get your foot in,” Hogan says. “And really start to understand what’s going on and how money can grow.”
While investing can be complex, there are easy ways to get started. The first step is learning more about investing and why it could be the right step for your financial future.
Originally posted at bankrate.com