Savings Or Investing: Which Offers Better Liquidity?

When it comes to personal finance, two key strategies for accumulating money are saving and investing. While both are important for building a solid financial foundation, there are distinct differences between the two. Saving typically carries little to no risk, resulting in lower returns, while investing offers the potential for higher returns but with the risk of loss. Liquidity, or how quickly and easily an asset can be converted into cash, is an important consideration when deciding between saving and investing.

Liquidity risk

There are two main types of liquidity risk: market liquidity risk and funding liquidity risk. Market liquidity risk occurs when an enterprise cannot execute transactions at current market prices due to insufficient market depth or disruptions. Funding liquidity risk, on the other hand, is the inability to obtain sufficient funding to meet financial obligations.

For financial institutions, such as banks, liquidity risk management is crucial and often regulated by frameworks like Basel III, which enforce stringent liquidity standards. Corporations also need to carefully manage liquidity risk by ensuring they have sufficient cash or access to credit to meet their financial obligations.

The repercussions of poorly managed liquidity risk can be severe and far-reaching. It can lead to financial losses, operational disruptions, and reputational damage. In extreme cases, it can even drive an entity towards insolvency or bankruptcy.

To effectively manage liquidity risk, institutions and corporations can employ strategies such as maintaining a portfolio of high-quality liquid assets, conducting rigorous cash flow forecasting, and diversifying funding sources.

Savings accounts vs investing in stocks

Savings accounts and investing in stocks are two very different concepts, and both are important for building a sound financial future. However, they serve different purposes and come with their own sets of advantages and disadvantages.

Savings accounts are a type of bank account where individuals can deposit and withdraw money as needed, with the added benefit of earning interest on their balance. These accounts are very liquid, meaning individuals can easily access their funds through various modes such as cheques and ATM cards. The interest rates on savings accounts vary but generally fall between 2.7% and 6%, depending on factors like the account holder's age. One of the biggest advantages of savings accounts is the low risk involved. The Federal Deposit Insurance Corporation (FDIC) guarantees bank accounts up to $250,000 per depositor, per FDIC-insured bank, and per ownership category. This means that individuals are highly unlikely to lose money kept within these limits. Additionally, savings accounts have minimal fees, making them a straightforward and accessible option for anyone. However, the downside is that the returns are relatively low, and there is a possibility of losing purchasing power over time due to inflation.

Investing in stocks, on the other hand, offers the potential for much higher returns. The Standard & Poor's 500 stock index (S&P 500), for example, has historically returned about 10% annually, although returns can fluctuate significantly from year to year. Stocks are also considered liquid assets, as they can be readily converted to cash. However, investing in stocks comes with a higher level of risk. There is always the possibility of losing some or all of the invested capital, and returns are not guaranteed. Additionally, individuals may need to hold onto their investments for longer periods to ride out short-term market downturns, which could impact their ability to access their funds when needed.

When deciding between saving and investing, individuals should consider their financial goals and risk tolerance. Savings accounts are ideal for emergency funds, unexpected costs, and short-term goals, as they provide easy access to funds and a guaranteed balance with low risk. Investing, on the other hand, is better suited for long-term goals, such as retirement or funding a child's education, as it offers the potential for higher returns over time. It's important to note that neither option is inherently better, and the right choice depends on an individual's financial position, timeline, and comfort with risk.

Emergency funds

It is generally recommended to save at least three to six months' worth of essential expenses. This amount can serve as a cushion during unforeseen events and provide financial stability. The specific amount may vary depending on personal circumstances, such as monthly expenses, income, and dependents. It is advisable to assess your financial situation and adjust the savings amount accordingly.

Where Should You Keep Your Emergency Funds?

Avoiding Risky Investments

It is generally advised to avoid investing emergency funds in stocks, mutual funds, or other volatile assets. These investments may lose value if you need to access the funds quickly, and you may be forced to sell at a loss. Instead, focus on lower-risk and more liquid investment options to ensure accessibility and preserve the principal amount.

Insurance and Borrowing

In addition to emergency savings, having adequate insurance coverage, such as health and disability insurance, is crucial. Insurance can provide financial protection during emergencies. Borrowing, such as through credit cards or loans, should be a last resort, as it can lead to high-interest debt and financial burden, especially during economic downturns.

Saving Strategies

Consider treating your emergency fund contributions as a regular bill to ensure consistent saving. Trim unnecessary expenses and redirect those savings towards your emergency fund to accelerate its growth.

High-yield savings accounts

• Interest Rates: High-yield savings accounts offer much higher interest rates than traditional savings accounts, with APYs about 10 times higher than the national average of 0.45%. As of November 2024, some high-yield savings accounts offer APYs of up to 5.25%.
• Accessibility: High-yield savings accounts are typically offered by online banks, and they provide easy access to your funds through online transfers, wire transfers, or check requests. However, online-only accounts may not offer branch access for in-person withdrawals.
• Safety: High-yield savings accounts are considered low-risk investments. Accounts at banks are insured by the Federal Deposit Insurance Corporation (FDIC), while credit union accounts are insured by the National Credit Union Administration (NCUA). This means your deposits are protected up to $250,000 per depositor, even if the financial institution fails.
• Fees and Requirements: Some high-yield savings accounts have monthly maintenance fees, minimum balance requirements, or withdrawal limits. It's important to review the terms and conditions before opening an account.
• Comparison to Other Investment Options: High-yield savings accounts offer higher interest rates than traditional savings accounts and checking accounts. They are more liquid and easily accessible compared to less liquid assets like real estate or stocks, which can take time to sell and may result in selling at a loss.

Overall, high-yield savings accounts are a great option for those seeking to grow their savings faster while maintaining easy access to their funds. They are ideal for emergency funds and provide a safe and low-risk investment option.

CDs (certificates of deposit)

Certificates of deposit (CDs) are a type of savings account that holds a fixed amount of money for a fixed period of time, ranging from 3 months to 10 years. In exchange, the bank pays a fixed interest rate that is typically higher than the rates offered on savings accounts. When the term is up, or the CD matures, you get back the money you deposited (the principal) plus any interest that has accrued. CDs are considered a safe, low-risk investment option because they are FDIC-insured up to $250,000.

CDs are a good option for those who want to save without taking on more risk. They are ideal for those who want to save for a specific goal, such as a down payment on a house, a new car, or a vacation. They can also be used as an emergency fund that earns a guaranteed return.

However, one of the downsides of CDs is that your money is locked into the investment. Withdrawing funds early from a CD usually incurs a penalty, which can significantly reduce the interest earned. Therefore, it is recommended to have an emergency fund in an easily accessible account, such as a savings account, before opening a CD.

CDs can be found at banks, credit unions, and brokerages, and it is important to shop around and compare rates and terms before opening an account.

Frequently asked questions