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The terms saving and investing are sometimes used interchangeably, but they are very different. One main difference is risk: saving typically comes with less risk than investing. But with risk comes the potential for higher returns. In this article, we will cover what saving is, what investing is, and the pros and cons of each, along with examples to help understand these concepts better.
Key Takeaways
- Saving is an excellent way to meet short- and long-term financial goals and prepare for unexpected situations, such as a car repair or medical bills.
- There’s little risk that you’ll lose money by saving it, but the interest rate on your account might not keep pace with inflation.
- Investing comes with risk, but also the potential for higher returns.
- Investing typically often comes with a longer-term horizon, such as for college funds or retirement.
Investopedia / Alice Morgan
What Is Saving?
People save money—that is, set it aside for future use—for various pre-planned purchases and also for emergencies.
You can use a high-yield savings account or a certificate of deposit (CD) that earns interest over time.
Savings are generally low-risk: your money is typically safe sitting in a savings account. However, the interest rates your savings earn will vary. There is a chance that the interest rate won’t be high enough to outpace inflation.
Tip
Generally speaking, short-term is considered to be periods of around one year or less. Keep in mind when you will need funds, what your plan is for the funds, and the safety/risk associated with the goal.
Example
One example of saving is setting aside a portion of your paycheck into a savings account every month. Let’s say you want to save $1,000 for a new laptop, and you have 10 months to do so. By setting aside $100 each month, you can reach your goal without having to pay interest on a loan or a credit card.
You can also use automatic transfers to ensure that you save consistently without having to remember to do so manually.
Pros and Cons of Saving
Saving has many benefits, such as providing a financial safety net for unexpected events, liquidity for purchases and other short-term goals, and being safe from loss. However, there are also some drawbacks to consider, such as missing out on potentially higher returns from riskier investments. Savings can also lose purchasing power caused by periods of rising inflation.
While saving is a crucial part of any financial plan, it’s essential to combine it with other forms of investing, such as retirement accounts or investing in the stock market, to achieve a balanced approach to financial planning.
Pros and Cons of Saving
Pros
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It builds up an emergency fund.
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It funds short-term or long-term goals, like going on a vacation.
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There’s minimal risk of loss. Savings held at banks are protected by the FDIC.
Cons
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There’s much lower yields.
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It may lose out to inflation.
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There are opportunity costs when not invested in riskier but higher yielding assets.
What Is Investing?
Investing is a way to grow your money over time by putting it to work in financial instruments such as stocks, bonds, and mutual funds. Unlike saving, investing involves taking on some risk, but it also has the potential to earn higher returns over the long term.
Investing is a way to reach long-term financial goals, such as saving for college, a down payment on a home, or retirement. Because investing involves taking on some risk, it’s essential to choose investments that align with your goals, risk tolerance, and time horizon. In general, the longer you can invest, the more risk you can take on, because you have more time to ride out the ups and downs of the stock market.
One important thing to remember is that investing comes with no guarantees, and there is always the risk of losing money. For example, if a company you bought stock in were to go bankrupt, your investment could be almost worthless. That’s why it’s essential to diversify your portfolio by investing in different companies and industries to reduce your risk.
Example
Using a 401(k) retirement plan is a good example of investing as it involves setting aside a portion of your income to invest in a diversified portfolio of stocks, bonds, and other financial instruments with the goal of growing your savings over time.
A 401(k) plan is a type of retirement account offered by many employers as a benefit to their employees. (There’s also a solo 401(k) for self-employed people.) With an employer-sponsored plan, you contribute a percentage of your salary to the plan, and your employer may match your contribution up to a certain amount. The money you contribute to the plan is then invested in a portfolio of mutual funds, stocks, and bonds that are chosen by the plan administrator.
The key advantage of using a 401(k) retirement plan is that it offers tax benefits. With a traditional, non-Roth account, the money you contribute is deducted from your taxable income, meaning you pay less in taxes. Additionally, the investments in your 401(k) grow tax-deferred, which allows your money to grow tax-free over time and potentially earn higher returns than a traditional savings account. With a traditional account, taxes are not due until you start drawing money from the account. (With a Roth 401(k), you pay taxes upfront and then withdraw funds tax-free in retirement, as long as you’ve had the account for five years.)
Investing in a 401(k) plan highlights the importance of starting to save for retirement as early as possible. By investing consistently over time, you can benefit from compounding returns and potentially grow your retirement savings significantly. It’s also important to choose a mix of investments that align with your risk tolerance and retirement goals, and to regularly review and adjust your investments over time to ensure they continue to meet your needs.
Tip
Financial experts do not recommend keeping very much of an investment portfolio in cash, because it can create “cash drag” and lower the potential returns of your portfolio.
Pros and Cons of Investing
Investing has the potential for higher returns than savings accounts, the ability to grow your wealth over time through compounding and reinvestment, and the opportunity to help you achieve long-term financial goals.
However, there are also some cons that should be considered. Investing always involves some level of risk, and there is no guarantee that you will make money or even get back what you’ve invested. Diversification across several holdings can help. It’s important to do your research and understand the potential risks associated with different types of investments. Investing requires discipline and a long-term perspective, which can be difficult for some people to maintain in the face of market volatility.
Pros and Cons of Investing
Pros
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Potential for higher returns than savings
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Can help achieve long-term financial goals
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Diversification can reduce risk
Cons
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Risk of loss, especially in the short-run
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Requires discipline and commitment
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May require longer time horizons
When To Save and When To Invest
Should you save or invest your money? The answer to this question will depend on your particular financial situation, goals, and risk tolerance.
When you are young, you may have limited income and expenses, but it’s never too early to start thinking about saving and investing. In fact, starting early can give you a significant advantage in building wealth over time. As a young person, you have time on your side, which means you can invest in riskier assets. Even if you suffer losses in the short-term, you have more flexibility to recover and benefit from the positive effects of long-term investing.
Important
By investing early and regularly, you can take advantage of the power of compounding, which means your money can grow exponentially over time.
As you get older and have a shorter time horizon, experts recommend shifting out of riskier assets like stocks and into more conservative ones like bonds and cash. This is because short-term volatility is more of a potential risk if the market crashes just as you’re about to retire.
Saving is generally a good idea if you have short-term goals, such as saving for a new phone, laptop, or vacation. Savings products generally offer low returns, but they’re also low risk. They are a good option if you need to access your money in the near future and can’t afford to lose any of it.
Important
Before you put any money into investments, be sure to have enough savings put away in an emergency fund to cover several months of expenses (three to six months is the rule of thumb), and enough money in your checking account to cover all of your short-term needs like bills, rent, and groceries.
Which Is Riskier, Saving or Investing?
By definition, saving entails very little risk. Investing, on the other hand, comes with the risk of losing money. Therefore, investing, in general, is riskier than saving.
Why Do Some People Prefer to Save Rather Than Invest?
Some people may choose to save rather than invest for a variety of reasons. Some prefer the sense of security of having more money set aside in a savings account for unexpected expenses or emergencies. Others may have a larger number of short-term financial goals, such as saving for a vacation or the down payment on a house, and prefer to keep the money in a low-risk savings account.
Additionally, savers may not have the knowledge or expertise to invest, or they may not feel comfortable with the level of risk associated with investing due to having a low risk tolerance. Finally, some may simply not have enough money to invest after covering their essential expenses.
How Much Money Should Be Saved vs. Invested?
The amount of money that should be invested versus saved depends on your individual financial goals, risk tolerance, and personal circumstances.
A good rule of thumb is to save enough to cover three to six months of living expenses in an emergency fund. You should also have enough saved in a checking account to cover short-term obligations like bills. Then, as long as you don’t have high-interest credit card debt or any lower-interest debt, like student loans, you should invest the rest. The specific amount that should be invested versus saved will vary depending on factors such as age, income, existing debt, and long-term financial goals.
Why Do Some People Struggle With Investing?
There are several reasons why some people find investing to be difficult. One common reason is a lack of knowledge or experience, which can lead to poor investment decisions. Additionally, emotional biases, such as fear or greed, can cause investors to make impulsive or irrational decisions that may result in losses. Successful investing requires a long-term perspective, discipline, and patience. It can be difficult to stay the course during periods of market volatility.
The Bottom Line
Saving and investing are important components of a healthy financial plan. With saving, you’re putting aside money regularly to build up a cushion that can help you weather tough times. In addition to that safety net, you can also save for your short-term goals, like a vacation. Investing, on the other hand, can help you achieve your long-term goals, like retirement. Whereas saving is lower risk than investing, investing has the potential for higher returns.
It’s important to find the right balance that works for your needs. Ultimately, a well-rounded approach that includes both saving and investing can help build wealth, protect against financial shocks, and provide a solid foundation for a secure financial future.
