Saving vs Investing
So often I read articles or blog posts that lament the low return on savings. They cite the interest paid on standard savings accounts or money market accounts which is hardly anything at all. Then they point out that the stock market has historically produced much higher returns than traditional savings accounts. All of this is true, but what bothers me is that the authors of these pieces talk of saving and investing as if they are the same thing. That is not the case. Saving and investing have very different objectives. It is important to distinguish between the two if a person is to make sound financial decisions.
Saving and investing defined
Saving is the setting aside of money for use when monthly cash flow from income is not sufficient to meet current expenses. The point of saving is to have money on hand when needed. Therefore, the primary objective is the preservation of capital. Savings is placed in guaranteed accounts that are FDIC insured. It is money a person can’t afford to lose. Return on capital is a relatively minor consideration.
Investing is putting money to work to earn more money. Investments often involve risk to capital and may tie up money for a period of time. Return on capital is the primary objective. However, the pursuit of return is tempered by risk tolerance. Preservation of capital is a secondary consideration.
Both saving and investing are necessary
Sound personal finances require both saving and investing. Saving avoids the need to take on debt and protects the established standard of living. Investing builds wealth for the future.
Excess savings is the source of money for investment. When there is more money saved than is needed to provide a backstop for monthly cash flow, the excess is available for investment.
Invest money that won’t be needed for years
Money that is invested should be money that won’t be needed for at least five to ten years, particularly if it is invested in the markets. Markets go up and they go down. Invested money needs time to ride out down markets. It may take years for markets to recover from a severe correction. The stock and housing markets are still recovering from the 2007 recession.
Money invested in cash accounts such as certificates of deposit and annuities has to remain in those investments for the term of the certificate or until the annuity surrender period has expired to avoid either early withdrawal penalties or surrender charges.
Investing in the markets involves risk of loss
A common piece of investment advice is: Don’t invest money in the markets that you can’t afford to lose. In other words, don’t put your savings at risk. Keep savings in an FDIC guaranteed account. Only invest money that is in excess of savings, and understand that some or all of the money invested in the markets could be lost. Know your tolerance for risk.
Investing without risk
Rosa and I have a low tolerance for risk. We couldn’t afford to lose any of our money whether it be our savings or investment money. We worked too hard to earn it. Even if we could recoup money lost in the markets later on, we couldn’t afford to lose the time. So we chose to invest in guaranteed cash accounts that protected our capital against loss and gave us a modest return. Currently, we have our money invested in five-year, FDIC insured certificates of deposit with maturities staggered over five years. In the past, we have invested in certificates of deposit with maturities that ranged from one year to ten years, fixed-rate annuities, U.S. Savings Bonds, and Treasury Bills. We relied on our ability to save rather than on higher returns to reach our financial goals.
Risk determines return
There is a reason why savings and money market accounts pay so little interest. It is because the money placed in them is not at risk and is immediately available upon demand. To earn a higher rate of return, money has to be invested for a specified length of time and/or put at risk.
Understand the difference between saving and investing, know what your objectives are for your money, know your tolerance for risk, and you will make better financial decisions.
K.C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages
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Thank you for your kind words. I hope you will return and continue to post your comments.