Smart Ways To Invest Your Savings

Saving and investing are both important concepts for building a sound financial foundation, but they are not the same thing. While both can help you achieve a more comfortable financial future, it's important to understand the differences and know when it's best to save and when it's best to invest. The biggest difference between saving and investing is the level of risk taken. Saving typically results in a lower return but with virtually no risk, whereas investing allows for the opportunity to earn a higher return, but you take on the risk of loss.

Savings accounts vs investments

Savings accounts and investments are two different approaches to managing your money. Both have their own advantages and disadvantages, and the best option for you will depend on your financial goals, risk tolerance, and current financial situation.

Savings Accounts

Saving refers to setting aside money in a low-risk, low-return environment, such as a traditional or online savings account, money market account, or certificate of deposit (CD). Savings accounts are ideal for preserving your money and are generally used for short-term financial goals. They offer a low level of risk, quick access to funds, and ease of use, but typically have lower potential returns compared to investments. It's important to note that savings accounts may not always keep up with inflation, which can erode your purchasing power over time.

Investments

On the other hand, investing involves using your money to buy assets that will ideally increase in value over time, such as stocks, bonds, exchange-traded funds (ETFs), commodities, or real estate. Investments typically carry a higher risk and require a longer time horizon, usually at least five years. They offer the potential for higher returns and wealth growth but come with the possibility of losing some or all of the invested funds.

Key Differences

The main difference between savings accounts and investments lies in the level of uncertainty about the money you'll get back. Savings accounts provide certainty, as you'll always get back what you put in, plus interest. In contrast, investments can be volatile, with the value of your money rising and falling over time, and there is a chance you may get back less than your initial investment.

Additionally, savings accounts offer immediate access to your funds, while investments may have barriers to access, such as penalties or taxes for early withdrawal.

The decision to save or invest depends on your financial goals and risk tolerance. Savings accounts are generally recommended for short-term goals, emergency funds, and situations where you may need quick access to cash. Investments, on the other hand, are better suited for long-term financial goals, such as retirement planning or building generational wealth.

It's important to prioritize saving if you don't have an emergency fund or if you need the cash in the near future. However, if you have already built up an adequate savings cushion and are looking to grow your money over the long term, investing may be a suitable option.

In conclusion, both savings accounts and investments play important roles in financial planning. By understanding the differences between the two and evaluating your personal circumstances, you can make informed decisions about when to save and when to invest your money.

Emergency funds

Potential Loss of Capital

When you invest in the stock market or other volatile assets, there is a risk of losing your initial investment if the value of your assets decreases. In contrast, keeping your emergency fund in a savings account preserves your capital, ensuring you have the funds when unexpected expenses arise.

Liquidity and Accessibility

Investments such as stocks, real estate, or retirement funds may be difficult or time-consuming to convert into cash. In an emergency, you want immediate access to your funds without penalties or delays. Savings accounts and money market accounts offer high liquidity and accessibility, allowing you to withdraw funds quickly to cover urgent expenses.

Tax Implications

Investing in a taxable brokerage account means you will be responsible for paying taxes when you sell assets and realise gains. The tax rate depends on how long you have held the assets, with short-term investments often taxed at a higher rate. Withdrawing from an emergency fund in a savings account does not incur these additional tax costs.

Volatility and Opportunity Cost

The stock market and other investments can be volatile, and you may find yourself facing losses during a market crash. This could coincide with a period of financial instability or job loss, leaving you without the safety net of your emergency fund when you need it the most.

Alternative Options

Instead of investing your emergency fund, consider placing it in a high-yield savings account. These accounts offer competitive interest rates, allowing your balance to grow slightly faster while preserving your capital. Money market accounts and certificates of deposit (CDs) are also suitable options, providing liquidity and the opportunity to earn interest.

Risk and return

Types of Risk

There are different types of risks to consider when investing. These include project-specific, industry-specific, competitive, international, and market risk.

Risk and Time

Time plays a crucial role in determining the appropriate levels of risk and reward. For example, if an investor can invest in equities over a long period, they have the potential to recover from the risks of bear markets and benefit from bull markets. Conversely, if an investor can only invest for a short time, the same equities present a higher-risk proposition.

Calculating Risk and Return

There are several ways to calculate risk and return, including alpha, beta, and Sharpe ratios. The alpha ratio measures excess returns on an investment, while beta shows the correlation between a stock and the benchmark that determines the overall market. The Sharpe ratio helps determine whether the investment risk is worth the reward.

Risk and Diversification

Diversification can help reduce the overall risk of a portfolio but may limit potential returns. A diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may carry high risk on its own, but if it is the only position of its kind in a larger portfolio, the overall risk is minimal.

Savings accounts, insured money market accounts, and certificates of deposit (CDs) are considered very safe because they are federally insured. However, the trade-off for this security and easy access to funds is that the interest rate on savings is generally lower compared to investments.

Stocks, bonds, and mutual funds are common investment products with higher risks and potentially higher returns than savings products. While there are no guarantees of profits when buying stocks, historically, stocks have provided the highest average rate of return over many decades.

Risk and Inflation

Even though savings are considered safe, they are not risk-free. The interest rate on savings may not keep pace with inflation, which means that money loses its purchasing power over time.

Risk and Emergency Funds

Financial advisors recommend having an emergency fund in a liquid account before considering investing. This fund should cover three to six months' worth of living expenses.

Short-term vs long-term goals

When deciding whether to save or invest your money, it is important to consider your financial goals and the time horizon for achieving them. Short-term goals typically refer to objectives that you are investing in for less than five years, while long-term goals are usually in place for ten or more years.

Short-term goals

Short-term goals involve amounts of money that can be saved relatively quickly, and the preservation of capital is of utmost importance. As such, it is advisable to choose less risky investments that offer more liquidity. Examples of suitable investment vehicles for short-term goals include cash management accounts, high-yield savings accounts, money market mutual funds, and certificates of deposit (CDs). These options provide competitive interest rates, flexibility in accessing funds, and lower risk compared to the stock market.

Long-term goals

Long-term goals, on the other hand, can withstand fluctuations in the stock market and have a much longer time horizon. Individual stocks, exchange-traded funds (ETFs), and equity (stock) index funds are powerful tools for long-term investment goals. These options offer the potential for steady growth and diversification. Additionally, robo-advisors can be a good choice for long-term goals as they provide automated portfolio management, tax efficiency, and relatively low fees.

In conclusion, when deciding between short-term and long-term investment goals, it is crucial to consider your risk tolerance, time horizon, and financial objectives. Short-term goals prioritize capital preservation and liquidity, while long-term goals focus on growth and can accommodate higher risk. By understanding your specific circumstances and goals, you can make informed decisions about the types of investments that align with your short-term and long-term objectives.

Financial advisors

Saving is best when you have immediate or near-term expenses that your monthly income wouldn't cover. It can take time to build up savings, but doing so means you avoid taking on high-interest debt because there's a guaranteed pot of cash to pull from.

• Saving your money entails a low level of risk.
• Some methods of saving are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration.
• Savings and similar accounts typically make it easy to access your funds.
• Most of these accounts do not require regular upkeep or observation.

And some of the cons:

• Lower potential returns compared to investing.
• Potential for savings accounts to fail to keep up with inflation, eroding your purchasing power over medium- and long-term time horizons.

Investing, on the other hand, is best for those who already have an emergency fund and are planning for long-term financial goals, or those who have a higher risk tolerance.

• Investing provides the potential for significantly higher returns than saving.
• As your investments grow, they allow you to take advantage of compounding to accelerate gains.
• Investing offers many different access points and strategies, from individual stocks and bonds to mutual or exchange-traded funds.

And some of the cons:

• In some cases, investments are less liquid than savings. It may take more time to access your funds, and it could potentially cost you money.
• Markets for stocks, commodities, real estate, and other assets are often highly volatile, meaning that you may not achieve gains and may even lose some of your principal.
• Some approaches to investing are very hands-on and require both time and specialized knowledge.

Frequently asked questions