Saving and investing compared
Saving money and investing are both great ways to improve your financial security and prepare you for an easy retirement, among many other things. However, people often see them as a this or that question: Ambitious investors claim there is not much reason to save while risk-averse frugal people consider investing as a total gamble. The general difference between the two is in their risk: saving money is very safe and risk-free compared to investing, which strives to generate profits long-term.
There is a place for both saving money and investing it and there is a clear benefit in doing both simultaenously. The purpose of this article is to cover the strengths and weaknesses of both approaches, why they work very well together, and how to combine them in practice.
Saving money explained
Saving money to a savings account monthly is generally much safer compared to investing. It involves practically no risk and builds a safe foundation to help with unpredictable financial issues down the line. It technically has debt-limiting effects as you need to be in a monthly financial gain to be able to put the monthly capital surplus into a savings account (though you could technically take out loans and put money into a savings account that way but that isn’t financially reasonable).
Saving money is a great habit because of two main strengths: it builds financial security and teaches consistency with money. It forces you to look at your finances and consider your monthly expenses carefully so that you are able to minimize costs and thus have more money each month.
The biggest downsides of saving are related to its innate nature: as it is based on steady, fixed deposits, inflation (which tends to be roughly 2 % annually) reduces the value of money every year so if your money is generating less than the amount of annual inflation in interest you're losing money. The second downside is that there is no exponential effect like in investing: You are saving roughly the same amount every year (unless your income increases) and thus your rate of accumulating wealth doesn't speed up. This is illustrated in the graph above.
Investing money explained
Investing always involves a certain degree of risk. Some mistakenly claim that investing in certain securities is risk-free, but this is not necessarily true. The rule in investing is that the greater the promised return, the bigger the risk. This is why extremely reliable government bonds only generate a very modest 1–3 % of annual interest, and some individual small stocks occasionally skyrocket up to hundreds of percentages of gains over just a few days with the included likely risk of losing all of your investment.
The investing defined in this article refers to a generally modest approach with a diverse portfolio including both some slightly ambitious securities that generate more annual income and some less ambitious securities that offer a more stable annual income, in the annual interest range of roughly 5–10%. As investing is an incredibly broad topic, it is important to highlight that investing in this article does not mean taking incredible financial gambles such as investing thousands of dollars in new unknown stocks or cryptocurrencies in the hopes that they will soon increase hundredfold in value. This to me is not investing but pure gambling, as no one can predict the market – at least sustainably. The market is influenced by more than thousands of individual factors and time and time again people have failed trying to predict its trajectory sustainably.
Investing in modestly reliable securities (that still always have some risk) that provide an average interest of 6–7 % annually is a great way to generate long-term income that builds wealth relatively fast thanks to the effect of compounding interest. Compounding interest means that not only does your invested security generate interest, but that the generated interest (”profits”) will then generate interest from itself, too.
The biggest downsides with investing are quite obviously the associated risk and the inability to use the asset during investment. You risk losing a lot of money (potentially everything you have invested) if you do not have a long-term plan regarding misfortune and financial crises. Once invested in a fund or stock, your capital is also not easily usable elsewhere on an emergency expense, for instead, and to withdraw the capital you often have to pay a transfer fee and at worst wait a certain time frame before you can sell the security off.
What is the relationship between saving and investing?
To put it simply, saving money builds a safe foundation that enables you to efficiently invest. Saving and investing are very deeply connected, which is demonstrated by a few realities: First off, you cannot really invest money sustainably without saving it. Sure, you can take out loans to invest, but this is unrealistic long-term – thus, investing is greatly dependent on efficient saving. Secondly, you can't attain significant wealth just by saving money, or at least ~98 % of us cannot. This obviously doesn't apply to career high-flyers with exponential salary development.
This relationship is interesting because there is a certain level of co-dependency: Investing obviously is not possible without saving money and a rainy day fund is necessary for times of income disruption. Then again, the value of savef money is reduced if everything is deposited into a low-interest savings account, so investing some of it can level out the value that inflation reduces.
Let's compare investing and saving with an example: Imagine two people, Frugal Frank and Ambitious Alex. Frugal Frank spends his weeks being very conscious about where he puts his money, and saves about $500 every month. Ambitious Alex is careful with money too, but instead invests $500 on various securities that offer a realistic and attainable average of 7% in annual interest. Let's compare their net worth over a period of 30 years using the Investor.gov compound interest calculator:
According to the Investor.gov calculator with a zero interest rate variance, Ambitious Alex would be a total of $390,070.85 wealthier than Frugal Frank, who is sitting at a meager $180,000 compared to Alex' $570,000.
Keep in mind that this example does not take into account Alex' income development, as at some point it would be more than feasible for them to increase their monthly deposit to $1,000, for instance. I think this example demonstrates quite explicitly how investing is clearly superior from a net earning perspective.
However, even the most cunning investors could be in for big trouble in case they are not planning for failure – this is where the utility of saving money steps in. Let's examine this in the following chapter.
Prerequisite for investing: Establishing a rainy day fund
The number one rule in investing is to only invest money you are ready and willing to lose. A new financial crisis could pop up at any moment and in that scenario your employment could very well be threatened. With your job potentially gone, you would need to figure out a new way to pay your running costs such as mortgage or rent. Due to the effects of the crisis, your investments most likely decrease in value, too. Now your $30,000 portfolio is suddenly worth $18,000, and it is suddenly supposed to cover your monthly food, mortgage, gas and other costs until you find a new job.
This is why you invest after you have established a rainy day fund. The size of the fund varies per person but I find that it should be able to fully support you for a minimum of 2–3 months in that dire situation where you lose your job due to an economic downturn or a sudden illness, and so on. This fund should also cover ALL of the expenses, not just rent or utilities, but all the realistic total monthly expenses that you need to survive, from food to car fuel.
In the ideal scenario you have a big healthy rainy day fund – a convenient asset that you can quickly realize to deal with any situation. If necessary, you can withdraw the required amounts from the fund while keeping your portfolio invested. That way you don't incur the massive cost of having to realize your investment assets at their lowest value in a long while (assuming that your unemployment is due to an economic downturn and thus the market is also performing badly).
Starting investing: Monthly savings to be invested
Once a rainy day fund has been established and it contains enough money to safeguard you for a few months in case of financial adversity, you should begin investing. It is generally recommended that you only invest in familiar securities (such as company stocks) that you know and understand well. This way you have a rudimentary understanding of where you’re directing your capital.
A great way to further improve your financial security is to follow the 20/80 % principle. Save 20 % of your monthly capital surplus, and invest 80 % of it. It never hurts to have a bigger rainy day fund in case things get really bad. Sure, there is a small tradeoff as you could invest 20 % more capital every month, but preventing bankruptcy is infinitely more useful when your rainy day fund is small than the 20 % of extra investment.
I will not go into the specifics of investing strategy as that is an intricate topic that simply cannot be condensed into a small chapter like this. However, as an investor just starting out you would probably benefit from learning the difference between an ETF and a common stock, so check out the article here.
The Rational Society does not offer investment advice. The text stated above is only an opinion and is for informational purposes only.
The Rational Society is committed to presenting ideas related to the rational school of thought, facilitating personal development, overcoming challenges and fulfilling ambitions. It is not a dogmatic ideology but an established mode of thought with the explicit goal of guiding the person to the most logical, healthy and beneficial choice.