As a financial planner, I work with clients of all ages and income levels. The basis of good financial planning is great communication between the clients and the planner. Clients are always encouraged to ask any question that pops into their mind. Recently, a young newlywed who is expecting her first baby was in the office and said: I have a very basic question: What is the difference between “saving” and “investing”?
That is a great question because many people think saving and investing are one in the same. In reality they represent two distinct ways of managing your money for the future. Not understanding the difference can be costly.
When you are “saving”, your intent or goal is to preserve the principle and not subject it to loss. Savings are also typically used to fund goals or needs in the immediate future (less than 5 years). Using a bank savings account, money market fund, US treasury bills, certain annuities or certificate of deposit are commonly used for saving. The downside to the “stability of principle” is that these savings options usually offer low returns when compared to other “investment” options.
Investing, on the other hand is when you place your money into vehicles that give you a greater potential for gain. But with the greater upside comes a potential for loss of principal as well. When you “invest” your intended use of the funds should be more than 5 years away. Having a long time frame is why most people invest in stocks, bonds or real estate, (or mutual funds investing in stocks, bonds or real estate) within their retirement accounts.
Different investment vehicles have different levels of risk. In general, bonds are thought to be less risky than stocks. It is important to keep in mind that some bonds are in fact more risky than some stocks. Having the correct mix of asset types is key to controlling risks, which is a whole other topic.
There are pitfalls when individuals “invest” for the short-term. This was very apparent to some with the recent downturn in the market. If you were intending to buy a new car with cash and you had it parked in a savings account, it would be there when you went to buy the car. If, on the other hand, you had invested the money in the stock market with the intent of buying the car in the summer of 2009, you would have lost part of the money for that new car and you instead might be buying a used car.
There are also pitfalls when individuals “save” for the long term. Saving vehicles rarely provide enough after tax return to exceed the inflation rate. Therefore, over time you will lose purchasing power and either need to start cutting back on your lifestyle needs or start spending principle.
In conclusion, savings is for the short term, where the return is low but there can be little possible loss of principle. Investing is a type of money management that seeks a higher return while knowing there is the potential for loss of principle. Investing is appropriate when the funds would not be needed for at least 5 years. Not understanding the difference is a common money management mistake.
This article is for informational purposes and should not be taken as legal, tax or investment advice.
Photo by: Fosco Lucarelli