Putting your money to work is one of the core pillars of wealth-building. This common but powerful mantra is the driving force behind strategically using your money to build a better financial future. But, as the world of financial services has grown in capability and complexity, the language of money has changed also.
Terms like saving, investing, and even trading in some cases, are used interchangeably even though they have very different meanings. To make matters worse, confusing these terms can have dangerous financial consequences. Get it right, and you could be on your way to becoming a retirement plan millionaire!
Even well-educated, high-net-worth professionals get these terms confused.
To that end, the team at Scarborough Capital Management offers this refresher on some of the key differences between saving and investing. If you have a question that’s not addressed here, contact us! We’re here to help.
Saving
Let’s begin with saving. On a basic level, saving is when you set aside money that you earn or obtain for emergencies or future use. The act of saving money can simply involve moving it from your commonly used spending accounts into a separate one.
Examples of savings vehicles are bank savings accounts, or any account that is otherwise separate from your spending accounts, typically offering extremely low risk of loss.
As you may know, risk (measured as market volatility) and reward (measured as investment return) are correlated when it comes to investments. Vehicles that offer low risk to investors typically also offer lower returns. This is the reason why the returns on your bank accounts are often lower than the returns you can obtain in the markets or elsewhere. Additionally, money used for saving should be reasonably liquid, meaning that the funds don’t require market-related activity to access the funds.
Saving has a few key traits to remember. It involves money set aside for an emergency or future use, is easily accessible when needed, and may earn a lower return over time. The characteristics of saving are completely different from investing. Saving may seem like an unsexy approach to money management, but it is an extremely important piece of your financial puzzle.
Without your savings, the money you need for a “rainy day,” like an emergency roof repair on your house, or a big purchase, like a family vacation, would be at the mercy of the stock market, or co-mingled with the constant moves of your checking account.
Investing
Investing, on the other hand, has a different purpose in your financial repertoire. Money is invested with the express purpose of growing in the future. Financial assets, the items that you purchase to help your money grow or generate new income, are the building blocks of investing. The number of financial assets available at your disposal is vast, with varying degrees of risk.
Stocks, bonds, mutual funds, even precious metals, real estate and fine art are examples of potential financial assets. Putting your money into these items can help your original investment grow, or can pay you future income through dividends and interest. Since the risk level of assets like these changes quickly and constantly, so too can their potential returns.
Oftentimes investing is long-term, where you can expect to hold an asset for at least one year, if not longer. If you have reason to expect that the money you are setting aside will be used in the short-term or near future, it’s probably better suited to be saved or could be invested using a strategy with a lower level of risk.
How much should you invest? Talk to a financial advisor to find out the appropriate balance between saving and investing in your financial plan.
Investing is a key element of retirement planning, and the sooner you start, the better. Depending on your age, the money in your Individual Retirement Account (IRA) or an employer-sponsored plan like a 401(k) or 403(b) will be used several years (if not decades) down the line. On top of that, retirement accounts have strict rules for withdrawals before a date in the future.
Not only should the funds not be touched or withdrawn (except for a serious emergency when you have no savings), but the IRS will also penalize you if funds are withdrawn before you turn 59 ½ (except in very limited circumstances).
When you invest, you are giving the money a chance to grow. Selling an asset and using the money in the short term eliminates its future growth potential, and you may even lose money if it has lost value during the short time it was invested.
There are a lot of misunderstandings about investing. Read our recent blog post: 5 Common Misconceptions about Market Volatility and Your Investments.
Remember the key traits of investing as you put your money to work for you. Investing is the act of purchasing financial assets like stocks, bonds or mutual funds, with the goal of having the investment grow to pay some form of income in the future. Time is a major factor in investing, and assets are usually held for well over a year. Most importantly, investing involves risk, which means that it is not guaranteed that you will make money and you could even lose money.
Why Saving and Investing Matter
Your financial life is a crucial mix of saving and investing, and not all dollars are treated equally. Investing is the vehicle that is intended to grow in order to help you reach your financial goals, and your savings will serve as a financial cushion in your time of need. While every investor’s blend of saving and investing is different, both sides of the financial equation are needed for a healthy financial life.
As you proceed in your wealth-building, always know the purpose of why you’re setting aside money, and whether it’s being saved or invested. If you need help, talk to a financial advisor to simplify your finances and develop a financial plan that covers both your savings and investments.
Having a clear understanding of the difference between these two sides of your money is a key factor in achieving – and maintaining – your wealth.
Contact Scarborough Capital Management and get the conversation started.