Heard the terms “saving” and “investing” used interchangeably?
Apples and oranges are both fruits, but that doesn’t make them identical. Ditto for saving and investing. You need to know exactly when and how to use each as you create wealth.
They’re far from the same, despite Average Joe’s confusion. But they do share a common goal: helping you build wealth and achieve your long-term goals. As you decide where to put the money you set aside each month, make sure you understand the different purposes — and risks — of saving versus investing.
Saving vs. Investing: What’s the Difference Between Them?
Leaving your savings in cash — whether physical bills or in a savings account — comes with no risk of losses, other than inflation. But your money doesn’t go to work for you either, reproducing baby dollars.
In contrast, investing means putting your money to work and hopefully earning a strong return, but it comes with risk of losses. Which dollars you put towards cash savings and which you invest depends on your goals and needs.
Saving money involves parking it somewhere safe, without expecting much (if any) return on it. Your goal: not losing a cent of principal while having easy access to your money.
Of course, “safe” means different things to different people. Some people don’t think there’s anywhere safer than their mattress or underwear drawer. They happen to be wrong, as anyone who’s ever been burglarized or had a home fire can attest, but mattress money still counts as savings.
More secure places to leave savings include a fireproof home safe or a bank account. The latter could include a checking account but more commonly means a savings account. Other banking examples include money market accounts and certificates of deposit (CDs).
The Federal Deposit Insurance Corporation (FDIC) insures all of these bank accounts, up to $250,000 apiece. So unless the federal government collapses — in which case you’ll probably have bigger problems — money parked with banks, credit unions, and other financial institutions is guaranteed safe.
Pros of Saving
Keeping cash in savings comes with plenty of perks.
- Virtually No Risk When Done Correctly. As outlined above, the federal government guarantees your savings held in bank accounts. And a fireproof home safe likewise keeps your cash pretty, well, safe.
- Liquidity. Most savings vehicles let you access your money at any time, with almost no restrictions. The glaring exception to this rule is CDs. Most CDs require you to leave money parked for a certain period of time.
- Stated Interest/Return. High-yield checking accounts, money market accounts, and CDs all tell you up front what interest rate they’ll pay you on your balance. No surprises, no volatility, just predictable returns on your money.
- No or Low Fees. In today’s world, it’s easy to find free checking accounts, savings accounts, and other bank accounts. Note that savings accounts do sometimes charge a fee if you take more than six withdrawals in a single month, though this is less common than in the past.
Cons of Saving
If saving had no drawbacks, we’d all just save money instead of investing it. Before you go old school with bricks of Benjamins in a safe behind your favorite painting, keep the following downsides in mind.
- Low Returns. You’re lucky to earn a 2% return on a high-yield savings account. That’s not going to get you anywhere fast, and doesn’t even keep pace with inflation.
- Losses to Inflation. When you invest money in stocks (or anything else), it comes with risk. But your savings is virtually guaranteed to lose money to inflation. If inflation runs hot at 6% for the last year, then you’ve effectively lost 4% of your money held in even a high-yield savings account paying 2%.
Safety ain’t cheap!
Investing money means saying goodbye to guarantees like FDIC insurance on your money. It comes with risk — but it also comes with far greater potential returns.
Examples of investments include money market funds, stocks and stock funds including exchange-traded funds (ETFs) and mutual funds, bonds, real estate investments such as REITs, real estate crowdfunding, and investment properties, hedge funds, precious metals, commodities, and countless other niche investments.
Each comes with their own pros and cons, but don’t get overwhelmed. You don’t need a degree in finance to start investing, you can just create an account with a robo-advisor if you’d rather start by automating it.
Pros of Investing
You don’t have much choice: if you want to retire one day, you need to invest money. Here’s why.
- Potential for Higher Returns. Over time, the average return on the stock market is around 10%, at least for U.S. stocks. That’s 100 times higher than the 0.1% interest many traditional banks pay on savings.
- Beat Inflation. If you ever want to build wealth, your returns need to outpace inflation. That’s virtually impossible with savings.
- Liquid Investing Options. Many investments do offer fast liquidity, so you can access your money any time. Examples include stocks and stock funds, bonds, REITs, and even a few real estate crowdfunding investments such as Concreit.
- Potential Tax Advantages. You can invest money in tax-advantaged accounts such as an IRA or 401(k), and get an immediate tax deduction. Even better, Roth versions of these accounts let your investments compound tax-free, for even greater tax benefits in the long run.
- Risk Mitigation Options. Sure, investing comes with risk, but you also have plenty of ways to mitigate those risks. For example, you can protect yourself against the risk of a stock market crash by also investing in low-correlation investments like bonds and real estate.
Cons of Investing
For all those advantages, you still shouldn’t tie every penny up in long-term investments. Investing plays a huge role in your personal finances and building wealth, but it still shares the stage with other actors.
- Risk of Loss. Your investments can and will lose money sooner or later. Back in 2012 and 2013, I thought I was very clever for investing in “pot stocks,” seeing the trend of cannabis legalization. But most of these companies were fly-by-night affairs that were poorly managed and had trouble accessing the banking system. My money — and my smugness — pulled a disappearing act.
- Volatility. Even if you invest in a diversified index fund tracking the S&P 500, which is nearly certain to rise in the long term, it still gyrates like a belly dancer in the short term. The liquidity is little comfort if you need to pull money out while the S&P growls in a bear market. That’s precisely why you should consider stocks long-term investments.
- Emotional Challenges. You work hard for your money, and the idea of losing it even temporarily is terrifying. And that says nothing of how intimidating it is when you first start looking into investing, trying to understand the lingo, the different types of stocks and funds, choosing a brokerage account, and so forth.
- Fees & Expenses. You can invest through free stock brokers nowadays, but that only removes one type of expense. Funds charge money each year, called an expense ratio. It also costs money to hire an investment advisor to get help, and even many robo-advisors cost money, albeit less than human advisors.
The Verdict: Should You Save or Invest?
Let’s be clear: everyone should do both. But that said, there are times when you should prioritize one over the other.
You Should Prioritize Saving If…
You should focus on saving first if:
- You Don’t Have Enough Emergency Savings. Everyone from janitors to Jeff Bezos needs an emergency fund to cover unexpected expenses and life events. Start by aiming for one month’s worth of living expenses in savings. From there, you can more gradually scale up to a few months’ expenses, and possibly as long as a years’ worth — depending on how stable your income and expenses are and how secure your job is.
- You Have a Big Upcoming Expense. If you’re saving for a big upcoming purchase, such as buying a house or car within the next 12 months, you likely need the safety of savings.
- You Have High-Interest Debt. If you’re carrying high-interest, unsecured debt such as a credit card balance, you should prioritize paying it off before investing money. After all, it hardly makes sense to invest money for a 10% return if you’re paying 24% interest on a credit card balance.
You Should Prioritize Investing If…
You should focus on investing if:
- You’re Eligible for Employer Matching Contributions. If your employer offers to match your contributions to your 401(k) or other employer-sponsored retirement account, take them up on it. You effectively earn a 100% return immediately on your investment.
- You Have an Emergency Fund. If you have at least one month’s living expenses in an emergency savings account, you can start focusing more on investing rather than saving. You may still want to thicken your emergency fund, but you can start splitting your monthly savings to go in several directions at once.
- You’ve Paid Off All High-Interest Debts. If you no longer carry any expensive unsecured debts, and only carry a home mortgage and/or auto loan, you’re in a great position to start investing.
- You Don’t Need to Tap Your Money Soon. If your financial goal is buying a car next month, then you should set aside that money in savings. But for longer-term financial goals, such as retirement or even saving a down payment for a home in a few years, you should invest the money. You have time to ride out short-term ups and downs in investment markets.
Not all investments come with high risk or volatility. Instead of a black-and-white view of saving versus investing, add some nuance by separating investments into short-term and long-term buckets.
Most stocks and real estate fall under long-term investments. But do some research into short-term investments for money you might need to access within the next year. These types of investments can prevent you from losing too much value to inflation, or to opportunity cost, for your short-term goals.
But on balance, use savings for your emergency fund and short-term goals, and investments to build the bulk of your wealth for the long haul.