“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for”
– Robert Kiyosaki
Whether you’ve got your first paycheck, or you’ve been earning for quite a while and you want to start working on your finances, it’s likely that you’re deciding between saving vs investing. How much money should you invest, where should you invest, is investing safe – are some of the questions that come up when confronted with the choice of saving or investing
So let’s break it down.
What is considered Saving?
Saving is when you set aside money in safe accounts or securities with virtually no risk. The objective is to save as much as money and keep it secure for future use. As long as you don’t make any withdrawals, the dollar amount in a savings account will not decrease. Also, your savings are a liquid option, meaning the cash is readily available, at your time and place.
A bank account, for example, is virtually a no-risk option when it comes to putting your money, besides you can access your money whenever you want.
Why should you save?
One might think that saving money isn’t really necessary when you can always get things on credit using credit cards or personal loans. And you’re right – you can buy things using your credit card and it’s quite easy to avail yourself of a personal loan when you have a bigger purchase to make.
However, with every purchase you make using your credit, you’ll end up paying more money than the cost of the product since there’s added interest for the money you borrowed. Whereas if you had enough money in savings, you only need to pay the cost of the product, nothing more. It might take a while to have enough money in your savings to make a bigger purchase – like a car. But it’s worth the wait.
Where should I save?
When it comes to savings, these are the most popular options
- Savings account
- Checking account
- Treasury Bills
- Certificates of Deposit (CD)
Keep in mind that, with Treasury bills and CDs there might be a minimum time period for which you should not make any withdrawals to get interest on your money. If you make an early withdrawal, you might have to pay a penalty, and you probably won’t earn any interest.
What is considered investing?
Investing is the act of committing your money or capital to an asset hoping to generate a profit. It is similar to saving, in that you’re preserving money for future use. But the difference between saving and investing is that, with investing you’re trying to get a higher rate of return on your money by allocating it to certain assets.
Generally, a profit from an investment would be through capital appreciation or active income. Capital appreciation is the increase in value of the asset over time – if you had bought Apple stock at $70 and waited a couple of years and sold it at $140, you’d have a profit of $70. Active income from investing will be in the form of dividends (stocks) and rental income (real estate), etc. Remember, not all assets provide you with an active income.
The goal of investing is to grow your money. For that, you need a high rate of return on your capital. The rate of return varies from asset to asset. But keep in mind that this is not a guaranteed rate of return. When it comes to assets like stocks, there are no guarantees.
However, historically, stocks have appreciated in value. On average, the stock market has produced an annual return of 13.9% in the past 10 years (2011-2020). For context, the average annual rate of return on a savings bank account is around 0.04%.
Why should I invest?
Before I answer this question, let me tell you what inflation is. Inflation is an aspect of the economy that results in a decrease in the value of money over time. Inflation leads to a decrease in the purchasing power of the currency – most of the products you could buy with $10 in 2010, can’t be bought with the same amount anymore.
The inflation rate is around 2% a year in the US. Whereas the interest rates for a savings account are close to zero. So ‘saving’ all of your money is not a good idea.
Investing helps you beat inflation. If you look at S&P 500, an index that tracks the prices of the largest 500 companies in the US, had an annual rate of return of 13.9% in the past 10 years. This shows not only you beat inflation, but you also managed to grow your money.
So to answer your question, investing allows you to grow your money over time, despite inflation.
Where should I invest my money?
These are the most popular options when it comes to investing:
- Funds – mutual funds, ETFs, etc.
- Real estate
Stocks are one of the most popular investment options. Investing in stock is the best way to grow your wealth over the long term. The stock market has consistently appreciated in value-generating profits of millions of dollars, for thousands of individual investors.
Consider this – if you had invested $10,000 in an S&P 500 index fund in 1993, it would be worth $95,370 today (as of 26 May 2021).
Saving and investing
Now we know what is considered saving and investing. The next question you might want to ask yourself, when should you invest and when should you save?
Well, that depends.
It is up to the individual to decide as per their financial goals, time horizon, and risk tolerance.
As a general rule, saving should come before investing.
There are a couple of reasons behind this. The first being, the money to invest should come from your savings. It makes sense, right? Savings should be the capital that fuels your investments. The last thing you want to do is to borrow money to invest.
Secondly, in the occurrence of an emergency where you require money on an immediate basis, you shouldn’t be in a position to sell your investments to raise cash. Since markets tend to be volatile in the short term you might end up selling your investments for a loss. To quote the legendary mutual fund manager, Peter Lynch – “When you sell in desperation, you always sell cheap”.
So you should ideally have an emergency fund. Also, the emergency fund should be able to cover all of your essential expenses for at least three to six months. And no, your investment is not your emergency fund. Even then, at the time of an emergency, you might be forced to sell your investment, if you’re short on savings. To avoid being in such a position, make sure you have your emergency savings ready.
Also, make sure you pay off your debts, especially ones with high-interest rates. Even though what is a high-interest rate depends on the individual, make sure to pay off anything with an interest rate above 10%. That includes credit card debt.
Another area you should take care of before you start investing is retirement planning. Whether it’s your 401(k), or IRA, make sure you invest and max out your retirement account. Especially if your employer adds a matching contribution. As these are retirement accounts have tax advantages, you’ll likely end up with a substantial amount of money.
Once all of these are in place, you can start investing.
When should you invest?
Invest for the long term.
Any amount of money that you reckon you wouldn’t need in the short term is worth investing in. As for when you should invest, start as early as possible. Because time is an important factor when it comes to investing. If you give more time to your investments, the returns will compound and then you’ll end up with a significant amount of money.
Invest for long-term goals that you don’t have a specific time horizon in mind, or you’re flexible with the timeline. The reason is, if the market is in a downturn when you’re thinking of withdrawing your money, you should be able to delay it for a while. So you can sell out when investments return to a higher value.
When should you save?
Save for everything that is short-term.
That means if you think you’ll need the money in six months, or a year or even five years, save it. Buying a house, for instance, is a short-term goal, as you plan to do it within a year. The money you need for this should be kept in savings, as you can’t predict when the market might go down, and if that coincides with your house purchase, you might be forced to sell your investments at a loss.
Saving vs Investing
All that being said, you need to look at the downsides as well. Should you go all-in on savings? That’s a bad idea. The interest rate on savings accounts is so low, you’ll end up losing the value of the ‘saved’ money over time, due to inflation.
How about investing all of your money? Not a particularly good idea. If you invest all of your money, you’ll be running short on cash for your short-term expenses, even for essentials.
Ideally, it should be a combination of saving and investing – you save first and then you invest. The allocation of how much to invest and how much to save is totally up to you. As I said, it depends on your priorities, circumstances, financial goals, and risk tolerance.
Know that investing isn’t that hard. If you’re someone who doesn’t have time to spare, you can buy an index fund and still get the average market return. But if you put in some time and effort, you can achieve substantial returns in the long run.
For a headstart, check out our Amazon Bestseller The 8-Step Beginner’s Guide to Value Investing.
Frequently asked Questions
Is it better to invest or save?
Ultimately it is up to each individual to decide. As a rule of thumb, you should ideally save first, and invest a certain portion of your savings.
Which is more important savings or investment?
Both are equally important. Avoiding one for the other isn’t ideal. You don’t need to invest a lot of money. You can start off with as little as $10 or $50, in case you don’t have a lot of money in savings. Remember, the money you invest in is the money that works for you.
How do I start saving and investing?
The key to start is to spend less than you earn. Plan your finances, layout your living expenses, and build up your savings. Even if the contribution to the savings is small, be consistent. Open a brokerage account and start investing small amounts of money, and slowly build up your portfolio.