Saving and investing are two different strategies for achieving financial security. Saving is the act of setting money aside for future use. Investing is the practice of buying assets to earn profits or income. Those assets can be anything from collectors' items to real estate, but securities such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs) are common.
Both savers and investors put off spending today with the goal of having more money tomorrow. This is one reason why you'll hear people use the words saving and investing interchangeably. Both strategies are aligned with the concept of financial discipline now in return for a wealthier future.
How saving and investing differ
When you save, you keep your unspent funds in cash. You might put the money in a high-rate savings account, a certificate of deposit (CD), or a shoebox in your closet.
When you invest, you trade in your cash for another asset. You then expect that asset to appreciate, produce income, or both. For example, you buy shares of stock because you're hoping they'll increase in value and/or pay you dividends over time. Or you might buy bonds or bond funds in order to receive interest payments as income going forward.
Pros and cons of saving
Relative to investing, saving offers these advantages:
Cash doesn't fluctuate in value. The balance in your savings account doesn't rise and fall according to what's happening in the economy or the financial markets. Even if the stock market loses 50% of its value in a day, your savings balance won't change.
Your savings are available to use immediately. Cash is liquid, meaning you can use it directly to buy things, pay bills, and repay debts. You can't "spend" stocks and bonds. Generally, you must first convert them into cash and then spend the cash.
Saving enables you to invest. You cannot invest unless you've saved first. This is true on two levels. First, the process of investing in the stock market involves depositing money into a brokerage account (instead of spending it) and then using that money to buy securities. The first step, depositing the funds, is an act of saving.
Second, it's best practice not to invest unless you already have an ample cash savings balance. This protects you from having to sell your investment assets before they've appreciated because of some unexpected financial emergency.
Saving also has two disadvantages relative to investing:
Savings provide negative returns after inflation. Even though your savings balance doesn't fluctuate in value, the spending power of your money does decline over time. This is due to rising prices, also known as inflation.
A normal inflation rate is 2% annually. At that rate, $100 cash on January 1 will only buy $98 worth of stuff by the end of the year.
Inflation presents a good reason to hold your extra money in an interest-bearing account rather than a checking account or a shoebox. The interest you earn helps offset inflation. A 2% inflation rate nets to 1.5% if the bank is paying you 0.5% on your savings balance.
There's an opportunity cost to saving since investing has higher returns. It's smart to keep some amount of spendable cash on hand for emergencies. But there's a cost to that beyond the negative real returns. By holding money in cash, you're also passing up the chance to invest that cash and earn inflation-beating returns.
Pros and cons of investing
Investing outshines saving in its return potential.
The return potential is high. Long-term, the average annual growth of the stock market is about 7% after inflation. At that growth rate, your invested assets double in value about every 10.5 years. You can access market-level growth easily, too, by investing in broad market index funds with low fees.
High returns are compelling, but they come with two downsides:
Your assets can lose value. Whatever you invest in -- from stocks to your own business launch -- is only worth what someone else is willing to pay for it. That amount can go up or down based on many factors that are outside your control.
You must sell your assets before you can use the funds. To use the value locked in your investments, you must find a buyer, settle on a price, and collect your cash. With publicly traded stocks and bonds, this process takes a few days. Other assets, such as real estate, can take months to sell.
Should you invest or save?
Most people need to save and invest, but knowing which is a priority now can be a challenge. Here are some hints that can help.
You need to save when:
- You don't have enough cash saved to cover three months of living expenses. This cash on hand helps you navigate through unexpected financial challenges such as job loss, injuries, and other emergencies.
- You are targeting a short-term financial goal. If you want to buy a home within five years or pay for your daughter's wedding next year, save. Investing is risky when the timeline is short.
You're ready to invest when:
- You can afford to keep the money invested. Investing requires a minimum timeline of five years. This is because the stock market can be volatile in shorter time frames. If you need the money, you may have to sell your stocks just as share prices take a temporary dip. That's a situation to avoid.
- You are preparing for retirement. Investing is ideal for long-term financial goals like retirement. A longer timeline insulates you from short-term volatility. It also gives you the opportunity to practice buy-and-hold investing. This is the investment practice of buying quality stocks or funds and letting them appreciate for decades. It's the simplest way to make money in the stock market.
With a solid budget, you can also save and invest at the same time. How much you should save versus invest depends on your situation. For example, you might contribute enough to your 401(k) to max out your free employer matching contributions. Meanwhile, you can pad your cash fund until it reaches your target balance. Later, you can shift away from the cash savings deposits and increase your 401(k) contributions.
Think of saving and investing as two levers you must pull to achieve financial security. Saving is for your short-term needs, and investing is for the long term. Master the skill of using both to achieve your financial goals, and you'll find prosperity on the other side.