Saving and investing are two key elements to managing one's personal wealth. In this article, we explore the benefits and downfalls of both these tools and give you a broader understanding of the topics.
What Does saving entail?
Saving money is an imperative step in building one's wealth and involves putting money away on a consistent basis, consistency is key. These funds are usually kept in an interest-bearing account, allowing the value to increase passively over the years.
In the United Kingdom, there are different types of ISA (individual savings accounts) that offer tax-free savings options.
In order to save, one must be spending less than they're earning.
What does investing entail?
Investing involves buying an asset with the intention for it to accumulate in value. This typically comes after saving, although the earlier the better. People invest in the likes of stocks, commodities, property and even themselves (education, capital for a business) in the hopes of generating returns.
What's the difference between saving and investing?
The biggest difference between the two is the varying returns you can earn. Saving money in a bank account typically provides returns of 0.5 - 2% depending of the period in time, while the return potential on stock could be much greater.
The other main difference between saving and investing is the risk. So, while earning higher returns on investments might sound much more appealing, the risk is usually greater. Savings accounts carry minimal risk and are usually insured while investment portfolios will rise and fall with the market and are only insured if the investment company fails. Investors should balance the options and establish which risk level they are comfortable with.
In light of these risks, savings are recommended for short term goals while investments cater better to long term financial objectives. This is because long term investments will ride out the ebb and flow of markets and recover even if there is a drop over a certain period. Savings on the other hand are more easily accessible and won't be "interrupted" if the funds are used for an emergency.
However, savings are also susceptible to inflation as the interest rates are seldom higher than the inflation rates. For example, if your bank is offering a 0.6% interest on your savings account and inflation rose 2%, your savings would have actually decreased in value. Investing typically beats inflation.
The similarities between savings and investing
As both tools are excellent at building and creating more wealth, there are bound to be similarities between the two.
The main similarity between the two is that both options are best started now, whether you're in them for the long or short term benefits. This is due to compounding. Compounding is the process where the interest you earn on an investment or savings account is continuously reinvested, increasing the base sum each period.
For example, if you put $1,000 into a compounding savings account and earned 2% interest each year. The next year you will be earning 2% interest on the lump sum plus the interest earned, $1,020. The next year you would earn $1,020.40 ($1,020 interest earned, $20.40). This doesn't sound like too much, but over a ten-year period, you would have amassed $219.20 without having done a thing.
Before you get started
Before getting started on either of these options, ensure that you have a positive cash flow and are debt-free. You'll also need to establish what your risk tolerance is, your short term and long term financial requirements, and when you would like to access the money.
If you don't have one already, you'll want to establish an Emergency Fund that can cover your living expenses for 3 - 6 months. Should you lose your job you can then fall back on this loan and not have to rely on credit cards with high-interest rates.
Experts also recommend setting up a retirement fund, with automated monthly contributions. Once your emergency and retirement funds are established, you can consider a short term savings account or long term investment, or both.
Pros and cons of saving and investing
Below we highlight the pros and cons of both tools:
Saving
Pro: Money is accessible and can easily be withdrawn.
Pro: Exempt from market volatility.
Con: Cannot leverage on market gains (potentially missing out on large compound interest benefits).
Con: Susceptible to inflation.
Investing
Pro: Longer time frames allow for favourable compounding interest.
Pro: Could tap into large market gains.
Con: Exposed to more risk as markets are susceptible to drops.
Con: May incur a penalty if the money is withdrawn too soon.
The bottom line
Both savings and investment options carry their own set of risks and rewards and it's ultimately best for you to speak to a financial adviser who is able to provide you with calculated professional advice.
This article is for general information purposes only and is not intended to constitute legal or other professional advice or a recommendation of any kind whatsoever and should not be relied upon or treated as a substitute for specific advice relevant to particular circumstances. We make no warranties, representations or undertakings about any of the content of this article (including, without limitation, as to the quality, accuracy, completeness or fitness for any particular purpose of such content), or any content of any other material referred to or accessed by hyperlinks through this article. We make no representations, warranties or guarantees, whether express or implied, that the content on our site is accurate, complete or up-to-date.
