Now days, there are more changes to invest than ever. It’s common to see advertisements for brokerage firms, ETFs, and even cryptocurrencies, but many of these opportunities are short-term trading. Investing is a long game designed to increase your purchasing power over time. So what’s the difference between investing and saving? In short, it’s about risk tolerance and time frames. Saving and investing are both necessary, but it’s up to the individual, or family, to decide how much of each to do.

Goals for Savings

The phrase ‘saving for retirement’ is a bit of a misnomer. When we save for retirement, we are really putting funds into an investment account that can grow over the decades as we age. But these retirement accounts are often illiquid and money can’t be taken out without penalty. ‘Investing for retirement’ is a better way to say that phrase since your savings should have a much different purpose.

Your goals for building savings should stretch out over decades. That is because the true nature of savings is to protect yourself from short-term shocks to your income or spending. A job loss, car accident, or unexpected medical bill can be a devastating hit to your personal finances, but significant savings allows you to cushion that blow.

Savings need to be liquid, insured, and accessed quickly in an emergency. That’s why so many people refer to their savings account as an emergency fund. Unlike stocks and bonds in a brokerage account, savings accounts can be tapped for cash instantly and your deposits may be FDIC insured to specific limits. But the drawback here is obvious – savings accounts offer such meager interest rates that your cash won’t even keep up with inflation. Money in a savings account loses purchasing power over time, but that’s the price of liquidity and security.

Goals for Investing

Investing in stocks has been a successful wealth preservation strategy for decades. In the long run, stocks may produce far greater returns than cash and cash equivalents like savings accounts, CDs, and money market accounts. Owning equity in an operating business is part of the American dream, but it’s important to draw the distinction between investing and saving.

When we save money in a savings account, it’s because we can’t afford to lose that money. Yes, inflation will ding our purchasing power a little every year, but you won’t see drastic fluctuations in your balance or ability to buy things. Investing involves risk because stocks can decline in value – and declines occur frequently.

Stock and bond investments will likely provide a better return over time than a savings account, but that’s because these financial assets carry risk. If stocks never declined, returns would inch down toward the risk-free rate (i.e. US Treasuries) since risk is required to produce outsized returns. The days of earning 5% in a savings account are likely over for good, so capital must be preserved in other ways.

Balance Saving vs Investing

If stocks offer better returns than savings could ever dream of, why bother with savings at all? Here’s a scenario: let’s say you have $10,000 in savings and a $50,000 investment portfolio. Halfway through the year, you suffer an injury that requires surgery and rehab. The out-of-pocket medical costs are expected to be in the $6,000 range. However, at the same time, the stock market hits a bear market and your investments decline 20%. If you didn’t have a savings account, you’d be forced to liquidate your investments at the worst possible time. And if your investments were in a tax-deferred account like a 401(k), you’d face withdrawal penalties from the IRS.

Investing and saving are both important aspects of a healthy financial life, but they must be balanced. Someone who plows all their money into stocks and bonds may find themselves forced to liquidate at inopportune times due to emergencies. On the other hand, someone who eschews the capital markets and keeps everything in safe savings vehicles will likely need to work longer as inflation eats away at their nest egg.

What’s the proper balance? That varies from person to person, but you should start with your savings goals first. How much do you need to put away to feel safe in the face of an emergency? A good rule of thumb is to have at least 2 months worth of expenses in savings at all times. Once you’ve built up some savings, you can utilize more money for investing, especially if you have a tax-deferred account like a 401(k) or IRA. But if you’re forced to drain your savings, be sure to trim your monthly investment contributions and refill your savings account. No one can predict the future, but expecting the unexpected is a good way to remain prepared.

Disclosures

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price.