What’s the difference between saving and investing?
“Saving” refers to money that’s readily available, and not subject to stock market (or other) risk.
“Investing” refers to subjecting your money to a suitable level of risk, anticipating it to grow over the long term.
Both saving and investing should be part of your financial planning.
The Role of Risk in Saving and Investing
The role of risk is important in making a decision about how much to save and how much to invest.
Because savings may be necessary to fund emergencies and deal with unexpected events (like the loss of a job), these funds should not be subject to any risk. They need to be available when you need them.
You may be familiar with the term “risk free rate of return.” It refers to an investment that carries as little risk as possible (since every investment has some risk associated with it).
Investing in short-term government debt, like Treasury Bills, is generally considered to be “risk-free”. Treasury Bills are backed by the full faith and credit of the U.S. government, which has never defaulted.
The market for Treasury Bills is huge and very liquid. As of April 2022, $23.7 trillion was invested in them.
Other examples of risk-free investments are savings accounts that are FDIC insured (up to $250,000) and short-term certificates of deposit in an FDIC-insured account.
Because these investments have minimal risk, they have low returns. They are suitable for funds you allocate to savings because you may need them in the short term.
For funds you can keep invested for the long term, you will need to have at least a portion of your portfolio invested in stocks, which carry a higher level of risk, but also have the potential for greater returns.
How Much to Save?
The total amount of savings you should have varies based on your unique situation. If you are confident your employment is not at risk, you might decide you don’t have to plan for being out of work in the near future.
If you are concerned about having enough cash to deal with unexpected events, and nervous about investing in the stock market, you might want to increase your cash reserves.
As a general rule, experts advise having enough cash to cover three to six months of expenses based on your average monthly spending. More conservative investors might want to increase that amount to 12 months.
Another issue to consider when calculating your savings requirements is your short-term goals. If you will need access to your funds to go on vacation, buy a house or a car, or for any other reason, those funds should not be subject to stock market risk.
Here’s wise advice from legendary investor Peter Lynch: “If you need your money in less than 3 years, it shouldn’t be in stocks.”
How Much to Invest?
Investing your money is a process. It begins with a plan that takes into account your financial situation and the ability to set aside funds you can invest for the long term.
As a guideline, experts recommend you invest between 15% and 25% of your post-tax income.
When budgeting for investing, you may find this strategy helpful. You can break your monthly budget into three categories: 50% is allocated to your needs; 30% to your wants and the balance of 20% for paying off debt, savings, and investments.
It’s important to prioritize how your available funds are allocated.
First, you need to have sufficient funds to meet your monthly obligations.
Second, put a plan in place to reduce or eliminate debt, starting with high-interest debt (like credit card debt).
Third, Fund your savings account so you can deal with emergencies and other contingencies.
Fourth, Review your insurance needs (health, life, disability, homeowners). These needs vary depending on a number of factors, including whether you have dependents who rely on your income.
Now you are ready to invest.
Investing involves many decisions. An important one is allocating your investment funds between retirement accounts (like 401[k) plans) and taxable accounts, funded with after-tax money.
Are you comfortable managing your investments yourself? Or do you need professional help from a wealth advisor?
Depending on the complexity of your investing needs, if you require assistance, you may find all the help necessary by using low-cost robo-advisors, who use sophisticated software to manage your portfolio. You can find a list of robo-advisors here.
If you want more personal attention, or your requirements are more complicated, consider retaining a registered investment advisor. These advisors (known as “RIAs”) have a fiduciary duty to always act in your best financial interest. They are registered with the Securities and Exchange Commission or state securities regulators.
Understanding the difference between savings and investing will help you formulate a financial plan that meets your needs.