Understanding the difference between saving and investing

Is there a difference between saving and investing?

In many ways savings and investing can be considered two different sides of the same coin. They are related obviously because in both cases we are putting money away today to be used for a future need down the road. However, the way we view saving vs. investing should be very different. There are two basic criteria that determine saving vs. investing: time and risk.

Saving and “safe” both come from the same root word, and we should think of these things together. When I consider saving goals, safety and not necessarily return on investment should be my major consideration. Savings should be used when you don’t know for sure when you will need the money or when you know you will need the money very soon. Savings is appropriate when the primary concern is to make sure the money is available when you need it.

Investing on the other hand first and foremost implies long-term. This is money you are unlikely to need in at least the next 5 years. Because we are thinking long-term with respects to investing we are able to absorb a little more risk. The more risk you assume the more potential you have to make a better return on your money. (And naturally the more potential to lose. That’s why we are only thinking long-term.)

So let’s look at some examples:

1. Your emergency fund.

Even though you will have this money for the long-term, this is a savings vehicle. This is probably one of the most difficult concepts for a lot of people. Many people have a hard time with the thought that you might have $20,000 or $30,000 just sitting in an account making very little. That much money needs to be doing something!!

Well the problem is this money is for emergencies and you never know when you may have an emergency. Let say you had your emergency fund  invested in the stock market. It’s March 2009. The market hits bottom and your 6 month emergency fund is now looking more like 2 and a half months. You boss walks in and says the company isn’t going to survive and your position is eliminated. Now when you most need that 6 month emergency fund you find more than half of it is gone.

This is not a position in which you want to find yourself.

You also don’t want to “invest” your emergency fund in things like CDs. The problem is if you need your money you will be penalized if you need to make an early withdrawal on you CDs. The temptation when that emergency hits will be to borrow money rather than have to pay the penalty.

The important thing to remember is that your emergency fund is really more insurance than savings. Your emergency fund is your Murphy insurance. Since you can’t predict when Murphy will show up, you want to be sure your money is safe. Availability is more important than return for this item.

2. Short-term savings goals.

This would be for large ticket items that you know you are going to need to take care of in the next 5 years. Examples of this would be your car replacement fund, your home repair fund, perhaps you have a major appliance that is on its last leg, maybe a vacation fund, maybe you know you’ll need to replace the roof on your home in the next couple years. You get the idea. These are items where you are going to need your money in a defined time period that is not too far into the future. This money also should be considered savings. You don’t want this in a risky investment when it’s time to replace your vehicle and find your Camry fund is now more of a Yugo fund since the stock market took a large dive.

3. Retirement savings

This on the other hand is almost the definition of a long-term investment. The beauty of retirement savings is time is on your side. Unless you are already very close to retirement age you have time for your investments to go down and then recover. An investment like a good mutual fund is more risky than a savings account at your local bank. On the other hand, it also provides you an opportunity to get a much higher return on your money; whereas you’d be very lucky these days to find a savings account that approaches 1% interest. The stock market in general has averaged close to 12% since its inception. In the short-term, the market is extremely volatile. In any one year you might be up 50% or down 50% or more. But when it comes to investing, we aren’t looking at a 1 year time span. We are looking at periods of years. For example 2008 was a horrible year for the markets. The S&P 500, one of the leading indexes lost about 37%. But then in 2009 it gained back about 26%. The market in general is a roller coaster, but if you are able to stay in it for the long haul the trend is always up when you look at extended periods of time.

4. College savings

This one can be a little trickier. It depends a bit on what age Jr. is. If Jr. is 2 years old then you should consider this an investment. You have plenty of time before college for the market to bounce around a little. If Jr. is 17 though you probably want these investments moved to something much more conservative. You no longer have the time to recover from a down turn like we saw in 2008.

The bottom line is you need to have savings and depending on the purpose you need to make sure your savings is kept in the appropriate place. If the savings are something you are going to need very soon or at unexpected times, then availability and safety are more important than how much return you get on your investment.

If on the other hand you are looking at saving the money for a long time, then you can safely take more risk. And you should take more risk as you need to make sure you are earning enough to beat taxes and inflation. You’ll never manage that with a “safe” savings account. You can afford to take the risks that allow for a higher rate of return because you can won’t need that money for many years. You can ride out the roller coaster ride that comes with riskier investments.

Lastly, I would say unless you are a professional financial advisor, don’t try to do this on your own. There is a word for day traders – broke! Find a trusted advisor that has the heart of a teacher and is willing to take the time to understand your situation and devise an appropriate plan for your needs. If you do not have someone like this visit Dave Ramsey’s ELP’s for investing.

Photo credit: 401k

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