Most of us know that there is a difference between saving and investing. We hear the two words all the time, but what we don’t know is how they work together, and how those two aspects of our finances should be managed.
The difference between saving and investing is simple. If you need it soon, save it. If you don’t, then feel free to consider an investment.
The question is, what is soon? There is no perfect answer to that, but as a guideline, if you need the money in five years or less, it should be saved. If you don’t need it for 5-10 years or more, then consider investing.
What is Savings?
When you put money into savings, your first priority should be preserving your money! Your savings are short-term by their very nature. You want to put your money in places that are:
- Easily accessible – you can get to it right away.
- Guaranteed – you don’t want to lose that money for any reason.
- Liquid – there are no penalties or surrender charges.
In other words, put that money in the bank. BORING. I know!
Considering that you need this money safe, liquid, and accessible, you should understand that you may not be earning much interest. Low risk = low reward. However, that’s okay. That is precisely what a savings account should be – a place where you don’t lose money.
What Do We Save For?
Depending on our interests, families, jobs, habits, etc., your purpose for saving could be many different things. At the very least, I encourage my clients to save enough to have an emergency fund.
Next, think of things like a house, a new car, or a vacation.
Whatever your desires or plans are, having adequate savings is critically important to the process. Consider savings as the base of the financial planning pyramid. You want to have a decent amount of savings before jumping into the investment world.
What is Investing?
Investing is used to build wealth and is a long-term process.
Investing exposes you to market volatility, unlike money in your savings. When you invest in the market, you are assuming risk that the investment might go down in value. In exchange for taking that risk, you expect to earn a higher rate of return. If all goes well, the rate of return you earn may exceed that of bank savings accounts and other similar investments, or inflation.
Investing is often deemed appropriate after you have adequate savings. If you invest and lose money, you should have sufficient savings to cover your needs. This will allow your investments to stay invested in the hopes of recovering your loss.
That being said, investments take time. There are no overnight guarantees.
What Do We Invest For?
We invest for many reasons, but some are more common than others.
- Invest for Retirement– This is the big one. Many of you likely have an IRA, a 401(k), or some other retirement savings vehicle.
- Invest for College– College can be a bit of a hybrid between savings and investing. Depending on the time frame, it can make sense to keep this money in savings, or it might be appropriate to put it in an investment.
- Invest for Investing – I often run into clients who have maxed out their retirement plans at work, they have adequate savings, and they still have “extra”. We can help these clients establish tax-efficient investment accounts that are relatively liquid, but still long term in nature.
What Do Investments Look Like?
Investments can take on many different forms. Your investment risk tolerance, your time horizon, your financial situation, and many other factors will play into how your investments “look.” Some of the more common investment options are explained below.
- Individual Stocks – With an individual stock, you are technically buying a share of a company. You are a part owner (keep in mind that you likely own a small portion, so don’t start signing emails as the CEO). Buying a stock is inherently risky. You are taking the risk that the one company whose stock you purchased is going to do well. If it does, you win! However, if it doesn’t, you lose.
- Individual Bonds – When you buy a bond, you are loaning money to a company, a government, a municipality, etc. In exchange, they will pay you an interest payment. The riskier the company, the higher the interest you may earn (also, the greater the likelihood that you will not get your money back).
- Mutual Funds – You’ve heard the word diversification, right? Essentially, it’s the investment version of not putting all your eggs in one basket. When you buy a mutual fund, you are getting instant diversification which strives to help protect you in case one of those “baskets” happens to fail.
- Exchange Traded Funds (ETFs) – Exchange traded funds are relatively new additions to the investment world. They act very similarly to mutual funds in terms of providing instant diversification; however, they trade like a stock.
- Other products – There are a number of different products out there that offer investment solutions, including annuities, non-traded REITS, managed accounts, separate accounts, etc. Some of these may have a place in your portfolio, while others may not. Most importantly, you should understand that there are many different options.
“Asset allocation and diversification do not guarantee a profit or protect against loss. Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. . The bond market is volatile and carries interest rate, inflation, liquidity and call risks. As interest rates rise, bond prices usually fall, and vice versa. Change in credit quality of the issuer may lead to default or lower security prices. Any bond sold or redeemed prior to maturity may be subject to loss. ETFs are typically registered as unit investment trusts (UITs) or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. Some ETFs that invest in commodities, currencies or commodity- or currency-based instruments are not registered as investment companies. Unlike traditional UITs or mutual funds, shares of ETFs typically trade throughout the day on an exchange at prices established by the market. These ETFs are not managed by the issuer. Investors must buy or sell ETF shares in the secondary market with the assistance of a stockbroker. In doing so, the investor will incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling. Actual investment return and principal value of mutual funds will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Please obtain a prospectus for complete information including charges and expenses. Read it carefully before you invest or send money. A variable annuity is an insurance contract which offers three basic features not commonly found in mutual funds: (1) annuity payout options that can provide guaranteed income for life; (2) a death benefit; and (3) tax-deferred treatment of earnings. When applicable, the tax deferred accrual feature is already provided by the tax-qualified retirement plan (e.g. 403(b), IRA, etc.). The U.S. Securities and Exchange Commission (Investor Tips: Variable Annuities) has suggested that it may be more advantageous to make the maximum allowable contribution to a tax-qualified retirement plan before investing in a variable annuity. The separate account of a variable annuity is not a mutual fund. While separate accounts may have a name similar to a mutual fund, it is not the same pool of funds and will experience different performance than the mutual fund of the same or similar name. In addition, the financial ratings of the issuing insurance company do not apply to any non-guaranteed separate accounts. The value of the separate accounts that are not guaranteed will fluctuate in response to market changes and other factors. Variable annuities are designed to be long-term investments and early withdrawal may be subject to tax penalties and charges. The value of the shares of a REIT fund will fluctuate with the value of the underlying assets (real estate properties.) There are special risk factors associated with REITs, such as interest rate risk and the illiquidity of the real estate market.