Saving vs Investing: What’s the difference?
Differentiating between saving and investing is vital for financial security and a bright future. Although often used interchangeably, they are distinct. But if theres one thing you should know, starting early is key for long-term stability.
What is the difference between saving and investing?
Saving is the act of setting aside money to achieve short or long-term goals, typically held in a low-risk bank account. Investing involves using funds to buy assets with the aim of generating returns over the long term, usually with higher risk to achieve potential growth or income.
Saving and investing similarities
Savings and investing are two crucial aspects of personal finance that share common goals but serve different purposes. Both strategies involve setting aside money for the future, aiming to achieve financial security and meet various financial objectives.
By saving, individuals create a financial safety net for emergencies and to make purchases. They typically keep their savings in low-risk accounts, such as savings accounts, which offer easy access to funds without exposing them to significant market fluctuations.
On the other hand, investing involves allocating funds into various assets, such as stocks, bonds, real estate, or exchange-traded funds, with the intention of generating potential returns over the long term. Investing carries a higher risk compared to saving but also offers the opportunity for higher rewards and wealth accumulation.
Unlike savings, which usually preserve the initial amount with minimal growth, investing aims to grow the money through capital appreciation or regular income, depending on the investment vehicle chosen.
Despite their differences, savings and investing are complementary strategies for building a strong financial foundation.
Having a solid savings plan ensures a safety net for emergencies and immediate needs, while a well-thought-out investment strategy allows individuals to grow their wealth over time, combat inflation, and achieve long-term financial goals, such as retirement or funding education.
What are the pros and cons of saving?
Pros of saving
- Financial security: Building a savings cushion provides a buffer for unexpected events, such as medical emergencies, car repairs, or sudden job loss. Having a readily available emergency fund can prevent individuals from falling into debt or resorting to high-interest loans.
- Liquidity: Savings accounts offer high liquidity, meaning funds can be accessed quickly and without penalties. This flexibility allows for easy withdrawals when needed, making savings a reliable option for short-term financial goals or urgent requirements.
- Low risk: Traditional savings accounts in reputable banks are typically insured by government agencies, such as the Federal Deposit Insurance Corporation (FDIC) in the United States, covering up to a certain amount per depositor per institution. This insurance provides protection for the principal amount, making savings a low-risk option for preserving money.
- Short-term goals: Saving is well-suited for achieving short-term financial objectives. Whether it's purchasing a new appliance, paying for a wedding, or making a down payment on a house, keeping funds in a savings account allows individuals to accumulate money gradually until they reach their target.
Cons of saving
- Limited growth: One of the main drawbacks of saving is the relatively low-interest rates offered by traditional savings accounts. In times of low inflation or economic downturns, these rates might not keep up with the rising cost of living, leading to the erosion of purchasing power over time. A high-yield savings account might be an interesting alternative, but their risk is also usually higher.
- Opportunity cost: By keeping money in a low-yield savings account, individuals may miss out on potential higher returns that could be achieved through investing in other assets like those in the stock market, bonds, or real estate. The opportunity cost of not investing could hinder long-term wealth accumulation.
- Emotional spending: The ease of accessing savings might tempt individuals to dip into their funds for unnecessary or impulsive purchases, hindering progress towards their financial goals. Practising discipline and setting clear boundaries for accessing savings is crucial to avoid emotional spending.
- Inflation risk: Inflation poses a risk to savings, especially when interest rates are lower than the inflation rate. If the growth of savings does not outpace inflation, the real value of money decreases, making it challenging to maintain purchasing power over time, and even though balances won't show, savers do lose money in an inflationary environment.
While saving is essential for financial security and short-term needs, it's crucial to strike a balance between saving and investing to optimise wealth growth and protect against the erosive effects of inflation. A well-rounded financial plan should consider both saving and investing, tailored to an individual's financial goals.
What are the pros and cons of investing?
Pros of investing
- Potential for higher returns: Investing in assets like stocks, bonds, ETFs, or real estate offers the potential for higher returns compared to traditional savings accounts. Over the long term, well-performing investments can outpace inflation, preserving and growing the purchasing power of money.
- Diversification: Investing allows individuals to diversify their portfolios, spreading risk across different assets and industries. Diversification helps mitigate the impact of market fluctuations and reduces the overall risk exposure, increasing the chances of steady returns.
- Wealth accumulation: Investing provides an opportunity to build wealth and achieve long-term financial goals, such as retirement planning, funding education, or buying property. Compounding returns over time can significantly boost the initial investment.
- Hedge against inflation: Certain investments are seen as a hedge against inflation, such as stocks and real estate, tend to perform well during periods of inflation, acting as a hedge against the eroding effects of rising prices.
Cons of investing
- Risk: All investments carry some level of risk, and the value of investments can fluctuate due to market volatility, economic conditions, or company performance. There is a chance of losing part or all of the invested capital, especially in riskier assets.
- Emotional decision-making: Emotional reactions to market fluctuations, such as panic selling during market downturns or overly optimistic buying during rallies, can lead to poor investment decisions and hinder long-term growth.
- Time and research: Successful investing often requires substantial time, effort, and research to identify suitable investment opportunities and manage a diversified portfolio effectively. A lack of knowledge or expertise can lead to suboptimal investment choices.
- Tax implications: Depending on the type of investment and the country's tax regulations, investors may face tax implications on shares, which can impact overall returns. Tax planning is essential to optimise investment outcomes.
When should you start saving and investing?
Starting to save and invest early in life can significantly help one's financial well-being, but it’s important to have a firm grip on your living expenses and make sure you don’t have any high-interest debt, as most investments won’t be able to guarantee you a higher yield than any loan.
The power of compounding, where investment returns generate additional earnings, becomes more potent over time. By initiating saving and investment habits at a young age, individuals can harness the benefits of compounding and witness their money grow substantially. Even small contributions made regularly can accumulate into substantial sums, providing greater financial security and flexibility in the future.
Delaying saving and investing can result in missed opportunities. Every year of inaction represents lost time for investments to grow and generate returns. As individuals approach retirement age, catching up with savings becomes increasingly challenging. Starting early allows for a more balanced and gradual approach, enabling individuals to make smaller, more manageable contributions and build their wealth steadily.
Individuals should be encouraged to foster discipline and financial responsibility as early as possible. It will help them prioritise their financial goals and manage their spending habits and living expenses more effectively. Establishing these habits early on can lead to better financial decision-making throughout life, creating a more secure financial future.
The best time to start saving and investing is now.
What types of investments are available?
There are various types of investments available, each with its own risk and return characteristics. Here are some common investment options:
- Stocks: Stocks represent ownership in publicly traded companies. Investors buy shares of these companies on the stock market, and their returns are tied to the company's performance and stock price fluctuations. Stocks can offer significant potential for long-term growth but also come with higher volatility and risk.
- Bonds: Bonds are debt securities issued by governments, municipalities, or corporations. When an investor buys a bond, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity. Bonds are generally considered lower-risk investments compared to stocks, but their returns are typically more modest.
- Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds but are traded on stock exchanges like individual stocks. They offer diversification and are known for their lower expense ratios compared to some mutual funds.
- Real Estate: Investing in real estate involves purchasing properties or real estate investment trusts (REITs). Real estate can provide rental income and potential property appreciation but requires more significant capital and can be less liquid than other investments.
- Commodities: Commodities include physical goods like gold, silver, oil, agricultural products, and more. Investors can invest in commodity-focused ETFs or stocks to gain exposure to these markets.
- Cryptocurrencies: Digital currencies like Bitcoin and Ethereum have gained popularity as alternative investments. However, cryptocurrencies are highly volatile and considered speculative, carrying significant risks.
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Still unsure if you should start saving or investing?
Deciding between saving and investing requires considering your financial goals, time horizon, risk tolerance and personal circumstances. Ask yourself these questions to gain clarity:
What is the reason you need more money?
Short-term goals: Short-term financial goals typically involve expenses or purchases that you plan to make within the next few years. These goals could include building an emergency fund to cover unexpected expenses, saving for a down payment on a home, or paying for a dream vacation. In such cases, saving is the preferred option.
Long-term goals: Long-term financial goals are those that have a time horizon of several years or more. Common long-term goals include saving for retirement, funding a child's education, or achieving financial independence. For long-term objectives, investing becomes more suitable. With a longer investment horizon, individuals can take on higher risk and invest money in assets like stocks or equity-based mutual funds, which historically offer higher returns compared to traditional savings accounts.
How long do you have to get the money?
The time you have to achieve your financial goals is a critical factor in determining whether to save or invest. If your goal is relatively short-term, like buying a car within a year or two, saving is the better choice. Investing might expose the funds to market volatility and result in potential losses if the market declines during that short time frame.
In contrast, for long-term goals like retirement planning, where you may have a time horizon of several decades, investing becomes more advantageous. Longer time horizons allow for a higher degree of risk tolerance and the potential to recover from short-term market fluctuations.
How much risk are you willing to have to achieve financial goals?
Saving in traditional accounts is generally considered low-risk, preserving the principal amount. If you are risk-averse or cannot afford to lose money, saving might be a more comfortable option.
On the other hand, investing involves higher risk due to market fluctuations. If you have a higher risk tolerance and are willing to weather short-term volatility for potentially higher returns, investing might align better with your financial objectives.
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Savings vs Investing FAQs
This does not constitute financial advice nor a recommendation to invest in the securities listed. The information presented is intended to be of a factual nature only. Past performance is not a reliable indicator of future performance. As always, do your own research and consider seeking financial, legal and taxation advice before investing.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.