Rainy day funds, mad money, and emergency savings are concepts you’ve probably heard about your whole life. So, you likely embrace the importance of having a stash of cash on hand somewhere.
Your savings are important too — even critical in this unpredictable world.
And you, being a savvy investor, should also realize that a balanced investment portfolio is equally important to your future plans.
Before we evaluate if it’s better to save or invest, let’s look at a few key differences between the two approaches.
Personal Savings Account
The national average interest rates for personal savings are usually lower than other rates of return, but saving accounts do offer some tangible benefits for account holders:
Relationship with a personal banker
Easy access to funds when needed
Established financial history
Sense of security if the need should arise
Many customers who prefer to keep money in the bank have either been burned by the stock market or have succumbed to their fear of investing. They believe there is safety in a bank savings account.
The FDIC offers insurance up to a specific dollar amount, currently $250,000, with some restrictions. A depositor who has two similar deposit account at the same financial institution may not be covered up to the full amount on both accounts.
However, the point is not to debate the technicalities of FDIC insurance coverage but to identify the lure of traditional savings accounts. The open market trading system offers no such protection for investors.
So, what then, is the draw toward the stock market and other forms of investing?
For starters, let’s take a quick peek at some of the drawbacks of traditional savings accounts:
Generally, lower interest rates
Only minimum balances are eligible for higher rates
Interest is taxable in the year it is earned
Interest rate will not keep up with inflation
Temptation to withdraw funds
You may have noticed that the majority of challenges with traditional savings accounts center around the interest rate. As we discussed with several different bank products, the average rate of return is usually lower with these types of accounts.
A Closer Look at Interest Rates
A more significant concern with earning lower interest rates now is the reality that inflation rates continue to rise.
To understand the dynamics of interest rates, let’s review their relationship with inflation. Don’t worry; this won’t be a whole lesson in Economics.
For starters, interest rates and the rate of inflation tend to have an inverse relationship. Simply put, that means when one goes up, the other goes down.
How do you think that will impact the growth of your savings account?
The economy shrinks and expands in response to consumer activity, which includes purchasing and saving decisions.
When interest rates are high, people tend to save more and spend less. This reduces demand for products, and inflation slowly decreases.
Keep in mind that there are two different ways of looking at interest rates. You might be referring to the cost of borrowing money or the rate of return you’ll earn on your savings account.
When would it be important to know the cost of borrowing money? Home mortgages are the most commonly impacted sector, but auto financing and even personal loans are affected by changes in the economy.
One final definition to note here is one for bank rate. This is essentially the rate a central bank charges to other banks to lend them money.
That’s right! Even banks have to pay interest on their loans. But don’t worry, this won’t come up in conversation very often.
Investing vs Saving
Don’t be fooled by the title — there is certainly no competition between a savings account and an investment portfolio.
In fact, we’ve included this section just so new investors won’t get mixed up between the two types of accounts. Financial gurus almost unanimously recommend having a combination plan that consists of both investment and savings.
One way to clarify the difference between saving and investing is by the level of action required to manage the account.
Savings accounts are very passively managed. They sit in the bank and relax, growing at a slow but steady rate.
There is no real action required on the part of a saver. The bank handles all the maintenance and paperwork for statement savings accounts.
Investment portfolios require a bit more of a commitment from the owner. To effectively maintain an investment account, the investor should be willing to spend time researching and actively managing their investment vehicles.
Investors may review their accounts several times a day or only about once a week, depending on their personal availability and comfort levels.
One of the things an investor looks for when they build an investment portfolio is diversity. Remember that investment goals differ from one person to the next.
One investor may be looking for stability while another seeks high risk with a greater potential for high returns. Either way, the lesson here is that an investment account requires regular review and investor input.
Timing Is Everything
Well, technically, timing is not exactly everything. But, it’s important when a person is deciding whether to save or invest their money.
Throughout an investor’s lifespan, there will be times when it makes more sense to invest than save and vice versa.
How, exactly, are you supposed to know what time it is? Truthfully, this is not always an easy answer.
No one knows for sure what the future will bring. Although we don’t know just what tomorrow has in store, we do have general ideas about what to expect based on our current life circumstances.
For example, a young adult who still lives at home with their parents and works full time probably has enough extra money to invest in the stock market, right?
That seems like an easy yes, right? Consider if this young adult is also a single parent or wants to purchase a home within the next year.
Would either of those scenarios change your initial answer? They probably will make us reconsider our opinion, which is part of what makes this a tricky question.
A general rule of thumb suggests that you should use savings accounts for all your short term goals. Investment accounts should be relied on for long term goals and will adjust accordingly as those goals draw near.
Some examples of short term goals include:
Moderate to large purchases
Down payment for a new home
Emergency savings plan for household expenses
As you can see, many of these events may require access to funds with little notice or within a relatively short time period.
If you are planning to buy new furniture, a used vehicle, or take some day trips, you want to have funds available in a savings account.
Some examples of long term goals include:
Once in a lifetime vacation
College savings for a child
Early retirement, inheritance planning, and a year-long cruise around the globe will probably require a lot of advance planning.
Some investors just want to create an additional stream of income and utilize their investment knowledge for this purpose. They may invest heavily in stocks that pay dividends and reinvest those dividend payments.
Ironically, day trading probably fits better into the short term goal category. Although it involves investing in the market, actively day trading is done to earn additional income.
As promised, there aren’t any easy answers in this financial realm. But, we’ve covered enough ground that you can decide which strategy works best for your current personal circumstances.
Now that you can easily identify the main differences between timeframes, the decision of whether to save or invest should be a little clearer.
Why Not Both?
Say, there’s a great question! See how fast you’re picking up on the wonderful world of personal finances?
There are very clear benefits of dedicating funds both to investing and personal savings accounts.
For this tutorial, we are looking at some of the main reasons why investing is better than saving.
Investors often choose one of two approaches to this age-old dilemma.
The first approach is that savings alone is not enough. The average rate of interest earned on a personal savings account will not outpace inflation.
The second approach is that a savings account is an extension of your pocket cash rather than a viable way to earn money. Investors who subscribe to this theory believe that the most effective way to increase income is to invest.
Residual Benefits of Investing
Investing provides more opportunity for earnings than a traditional savings account. The investor is in control of how their funds are invested and can make changes to increase the rate of return.
While there are no guarantees, there is more flexibility within an investment portfolio than in a traditional savings account. Funds deposited in a savings account are invested according to the bank’s discretion.
Regardless of how well or how poorly investments perform, banks pay the same interest rate to their customers. The interest rate paid to customers is often woefully less than what the bank earned by investing the funds.
The difference between what it earned and what it paid is the bank’s net profit. As an investor, you have the option to eliminate the middle man and invest your funds in the market.
Over time, the savings interest rate paid by the bank won’t often change or by much. The residual effects of investing offer more ways to increase the initial investment amount.
For example, consider one customer places the same principle investment amount in a savings account and a self-managed investment account. To keep this example simple, let’s assume the initial deposit is $500 and the bank is paying 1% interest annually.
At the end of the first year, the customer ends up with $5 in earned interest from the bank. Of course, that is very oversimplified – but let’s check in our investor again.
Not sure where to invest, our investor splits his %500 between an energy company and an automobile manufacturer that pays a dividend. Our savvy investor sets up his account to automatically reinvest dividends back into the automobile manufacturer’s company stock.
Since our investor was able to purchase 100 shares of the company stock, and the automobile manufacturer paid a dividend of $.50 per share, our investor quickly saw an increase of $50 in their portfolio!
Our investor didn’t have the same luck with the energy stock, which is growing rather slowly. The daily market ups and downs only averaged about a 2% growth rate after several months.
The investor now has a decision to make about the energy company stock. And, this choice belongs solely to the investor, who doesn’t have to get input from anyone else.
Whether the investor decides to keep some funds in the energy company stock or move it all, he will have the choice to make a change at any time during normal market hours.
Funds in a personal savings account are solely subject to the bank’s discretion. The underlying investments are usually not even made known to the customer.
Interest rates can be increased or decreased by the bank without much notice, and the customer can’t do anything about it. Well, except move their money into an account they do control.
Accessibility of Funds
In a personal savings account, funds are invested by the bank but are also available at the customer’s discretion. As long as the bank or automated teller machine are open, the customer can withdraw cash from their savings account.
Investors who wish to make a withdrawal from their investment portfolio must go through a few additional steps.
First, the investor will decide which investment to sell. It makes the most sense to sell when an investment is worth more than when you purchased it.
After selling all or a portion of that company stock, the investor will receive their initial investment amount plus earnings. These funds are usually available immediately after settlement.
Depending on the investment clearinghouse, this could be within about 30 minutes of the trade. Some brokerage firms settle accounts overnight and make funds available the following business day.
The investor can then have the funds directly deposited into their bank account through ACH transfer. This may add another day or two to the process, but generally, these deposits are made available to the investor rather quickly.
Although funds invested in the stock market may not be immediately available on demand by the investor, the benefits still far outweigh the slight delay.
Flexibility and the ability to control how funds are invested, as well as the opportunity to gauge when to make changes, give the investor an advantage.
There are simply no options for the customer to impact the interest rate or investment style of their personal savings account.