Published in: Banks | Feb. 23, 2019
By: Lyle Daly
There's no understating the importance of saving money, with one common recommendation being to save at least 20% of your income every month. Whether you're saving a lot of your income or a little, the next natural question is what you should do with it.
The answer will depend in large part on your current financial situation and how you plan to use that money. But first, we need to clarify the difference between saving and investing.
Saving money refers to putting your money into cash products that you can withdraw from quickly and easily so that you have your money available if you need it at a moment's notice. Most people save using bank accounts, specifically saving accounts, as the old "shoebox under the bed" method isn't the most secure.
The main advantages of saving over investing are:
Investing is buying something that you expect to increase in value, with the point being to grow your money. Popular investments include stocks and real estate. There's more of a risk to investing because your investment could drop in value. It can also take more time to get money from an investment, because you need to sell it first.
There's one major advantage investing holds over saving, though, and that's the growth potential. High-interest savings accounts will earn a maximum of about 2% to 2.45% per year, whereas you could realistically earn 8% to 10% annually by investing.
There are two situations when saving is the way to go:
An emergency fund is a must for everyone, as it's the money you'll use to avoid going into debt if you have any type of emergency, such as a medical issue or a job loss. Conventional wisdom says your emergency fund should have enough money to cover three to six months' worth of your living expenses.
With large purchases that you'll be making within a decade or so, it's safer to save money. While investing could get you a better annual return on average, the average won't do you much good if your investments take a hit at the wrong time.
Examples of large purchases to save for include:
Investing is the best way to build wealth, but only if you can afford to give your investments plenty of time to grow.
You don't want to invest any money you may need in the near future, because you risk losing money should your investment not pay off right away. With some types of investments, such as stock purchases or real estate, you also must pay fees when you buy and sell, so it's best to hold your investments for a long time to minimize how much fees cost you (and, in the case of stocks, choose one of the best brokers to avoid overpaying on those fees).
This means the ideal time to start investing is after you have your emergency fund ready to go. At that point, you can put your extra money towards investments of your choosing.
Although there are times when you should focus on saving and others when you should focus on investing, keep in mind that you don't have to only do one or the other.
You should save for an emergency fund if you're light on cash there, but it also always helps to get started with investing sooner rather than later. This gives your money more time to compound, and if you have an employer-sponsored retirement plan where they match a certain amount of your contributions, it's important to take advantage of that opportunity.
Instead of putting all your eggs into the saving or investing basket, you could consider splitting your extra money between those two areas as you see fit. You can build your savings in case you need it, while also getting started on growing your wealth as soon as possible.
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