“Saving” and “investing” are terms that, while related, refer to different actions.
Don’t confuse the two, for each can lead to a very different outcome from the other. If you save money when you should be investing it, or vice versa, you could be severely handicapping your ability to reach your financial goals.
Think of saving as putting money aside toward a short-term goal – one you want to achieve in one to three years or less. Holiday shopping or a down payment on a new car are examples of short-term goals toward which you’d want to save. Investing, on the other hand, is putting money aside for a bigger long-term goal at least five years away, such as your child’s college education or your retirement.
Effectively saving toward a short-term goal means keeping your money in a safe place where you can get to it when you need it. While the money you save may earn interest, rates tend to be so low that any earnings would be practically negligible. But that’s okay – the trade-off is that your money is safe and accessible. If you are saving for a vacation, for instance, you need to know that every single dollar you put away toward that vacation will be sitting right there when it’s time to start packing your bags.
Checking accounts, savings accounts and short-term certificates of deposit (CDs) can be good vehicles for saving money, but make sure any account you choose is insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC protects the funds people deposit in banks and savings associations by insuring up to $250,000 per depositor, per insured bank, for each type of account. That means your money is safe. So safe, in fact, that since the FDIC was established in 1933, no depositor has lost a penny of FDIC-insured funds. Because accessibility is important too, also check the withdrawal terms and conditions up front to confirm you’ll be able to get your money back out without penalty when you’ll need it.
A long-term financial goal typically requires more money than you could comfortably afford to save out-of-pocket. Instead, you invest with the hope that over time, the money you put aside will grow by generating returns. Unlike saving, investing goes hand-in-hand with risk: the more you want your money to grow, the more risk you’ll likely have to take on. And because investing tends to be a long-term process, some investments make it difficult to quickly access the money you’ve put into them. The real advantage here is the potential for higher returns than you’d see from a savings account.
When you invest, you use your money to buy an asset you believe will generate a certain return over time. Your initial investment earns money if you sell an asset at a higher price than you paid for it. Stocks and mutual funds are considered attractive long-term investment options, but they can be quite volatile and thus susceptible to short-term drops in value. Whether you put your money into stocks and mutual funds or into real estate and comic books, all investment vehicles have some degree of risk and generally require a long-term commitment, so do your research and invest your money wisely.
Now that you know the difference between saving and investing, do not mix the two up by funding your short-term goals with money you’ve invested rather than saved. For example, if you view the money in your 401(k) account as savings, you may not see anything wrong with borrowing some for a down payment on a house or car. But imagine you’re planning to retire in 30 years when you decide to borrow $5,000 from your 401(k) account. That $5,000 loan at 5% interest could result in $52,000 less at retirement than you’d have if you hadn’t taken a loan. That’s a loss of more than 10 times the original loan value thanks to the hit your earnings potential – which is the primary reason for investing – would take.
Likewise, don’t make the mistake of taking money you’re going to need in the relatively near future and tying it up by investing it. It’s simply too risky to treat the short-term savings you should be protecting like long-term investments that could drop dramatically in value.
To cover your bases, make sure your financial strategy includes saving and investing.
Invest for the long-term and save for specific short-term goals. For example, if you know you’ll need money for the holidays each year, open a savings account just for the holiday season and automatically deposit a small amount from each paycheck. When you get itchy for a nice vacation or a new car, do the same thing – open a savings account specifically intended to fund that goal. Don’t forget to account for the unexpected needs that are bound to crop up and could lead you to dip into your investment accounts. Be proactive and start building an emergency fund instead.
If you’re not sure whether you should be saving or investing toward a particular goal, remember the basics: if it’s a short-term goal for which you need to protect and be able to access your money, start saving. If it’s a bigger long-term goal for which you are willing to risk safety in exchange for growth potential, then consider investing. If you’re still not sure what to do (or how best to do it), speak with a financial advisor who can help.