Often used interchangeably, here is my take on the difference between saving and investing that further clarified my own perspective on money management when I was learning the subject.
The two are quite different, but many still interpret these terms interchangeably. This misunderstanding leads to mismanagement, sometimes loss of money, loss of the potential to earn more money or disappointment because a planned big ticket purchase could no longer be made because the money “saved” has decreased in value or buying power.
Financial celebrities like Dave Ramsey and Suze Orman specifically distinguish between saving and investing anytime they write a personal finance book or give lectures on financially responsible living.
A background on these terms and what they mean usually comes quite early in the material as it is an important fundamental difference in managing money that needs to be understood.
The simplest way to understand the main distinction between the two is to think of “savings” as anything needed for short term purposes. “Investing” on the other hand is for long term purposes.
We all work to earn money, and we all have bills we pay every month. What is left after we pay all our bills is the surplus, also referred to as savings by many.
Although we call it savings, it is not quite the same “savings” that I am talking about here. The “savings” I am talking about is what you do with that surplus left over after paying all your bills.
Well what are the options? You can go out and buy a new outfit for yourself, you can put it away in a savings account or you can invest it in your child’s future college fund or your retirement. These are three very distinct uses of the surplus, one of spending, one of saving and one of investing.
When you are saving money, you are usually saving for the short term. I define this as less than five years. Saving is typically done for planned purchases in the near future. For example, you might be saving up for a down payment on a house, or a new car.
Because these purchases are planned in the near term, you cannot afford to loose value or purchase power on your savings. This is sacred money and you must preserve your capital.
That said, I often recommend keeping money in a low interest bearing account like a savings or interest checking account. You can also look into short term CDs. All such instruments will preserve your cash, give you access to them in the short term and will also make you some money in interest.
Investing on the other hand is long term in nature. You don’t invest to buy a car, but you invest toward your retirement years down the road. You invest into your children’s college fund. You invest for a better “future”.
Long term investing is different from savings. When you are investing, chances are your money will be working in the stock market in some shape or form. Stocks go up and down in value in the short term, but historically have shown an average of approximately 8% return per year over a long term investing span of 10, 20, 30 or more years.
When you are investing, you are more concerned with the long term results. Watching your portfolio everyday may give you a heart attack because the stock market does go up and down like a roller coaster, especially within the recent past.
Two of the more common retirement vehicles used are the Individual Retirement Account (IRA) and the 401(k). An IRA is a retirement account you set up with your bank or financial institution while the 401 (k) plan is an investment plan provided by employers.
Government employees have something similar as well. In these accounts, your money is used to purchase income producing investments like stocks, bonds, mutual funds, precious metals, real estate, etc. These accounts provide tax incentives to encourage saving for retirement, and similarly penalize for withdrawing early prior to retirement.
Employers usually match employee contribution in these to an extent. For example, your company might say that if you invest in this plan, they will match each dollar you put in with 50 cents (essentially 50%) up to 6% of your income.
If you are making $45,000 a year ($3,750 a month), you are eligible for a company match up to 6% of that amount or, $2,700 every year ($225 a month). So if you contribute $2,700 a year into your 401(k) plan, your company will throw in another $1,350 (which is 50%).
Even though you only put in $2,700, your account will have $4,050 at the end of the year. This is free money. A 50% guaranteed instant return on investment is not easy to find anywhere else.
Investing in a 401(k) plan with a match just makes sense. Not doing so is equivalent to throwing money away. At the very least, one must invest at least up to the limit your company matches your contributions.
Some companies match 8%, some match 10%. Some companies even match your contribution dollar for dollar. In those cases you just CANNOT afford to ignore this investment vehicles.
In a previous life, my company matched 100% (or dollar per dollar) of the first 6% of my contribution. They also contributed an additional 3% regardless of my contribution behavior.
This is a difficult question to answer because we all have different levels of income and lifestyles. However, we all should put aside some money each time we earn it for a better future. We all know what the social security program is projected to do.
If you are living a financially responsible and conscious lifestyle, chances are you are left with a good amount of surplus each month after you pay the bills. A rule of thumb that I have followed and that has worked very well for me is that 8-12% of my money immediately goes into a retirement fund, whether a 401k or an IRA.
A discretionary percentage goes into a charity bucket, and a percentage goes into a savings bucket. The entire funding system is automated based on pre-specified rules so I don’t have to spend even a minute on it. It can really be that easy.
Setting up direct deposit automated arrangements between various accounts is how I am able to automate this process, and this especially works for those who have little or no discipline.
There are two specific benefits that stick out to me in doing this. First, if you don’t see this money, it will feel like you are not even earning it, yet your savings and retirement accounts builds steadily over time.
The second benefit is dollar cost averaging. When you are setting money aside in your retirement fund every month, the money is used by the fund managers to buy stocks, bonds, mutual funds, etc.
Because the value of these financial instruments fluctuate, contributing a steady amount every month ensures that you are buying them when they are priced high equally as much as when they are priced low.
For example, if you invest $100 this month, the fund manager can buy shares of company X stock worth $25 a share. Next month, company X’s share price may drop to $20. So if you contribute another $100 next month, you will get 5 shares of company X stock instead of 4.
So now you have a total of 9 shares for a total investment of $200. $200 divided by 9 is $22.22. This is the amount you paid per share of stock over a two month period. This kind of investing minimizes your risk and historically has led to positive long term gains.
This was a summary of my perspective on saving and investing. This perspective has helped me become a better manager of my finances.
Depending on the level of financial savvy you are at, this may be old news to you. If you are relatively new to personal finance, I hope you took away a thing or two.
If you are looking to read and learn more about the subject of saving and investing, as well as personal finance in general, two good starter books are Suze Orman’s Money Book for the YFB and Dave Ramsey’s Total Money MakeOver
What about you? What are your thoughts on saving and investing? Do you see it in another way? Do you have any specific tips that can help our readers become better money managers?
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