Saving Versus Investing
How to decide where your next dollar belongs
Personal finance does not need to be complicated. Follow a few principles and you should do fine:
- Save for a rainy day
- Invest for the long run
- Don’t spend more than you make
These seem straightforward enough. However, words and labels can be confusing. What is “saving?” What is “investing?” What’s the difference? What is the opportunity cost of saving when you should be investing, and vice-versa?
None of us was born knowing this stuff
I often tell clients, coworkers, and students: None of us was born knowing any of this stuff, by which I mean the mechanics of our financial world and all its vocabulary.
The finance sector entails lots of jargon. While it might make communicating easier to insiders, it can make smart people feel lost for no good reason because the differences are not always clear.
For example: I’m supposed to invest for retirement, however my employer offers a 401(k) retirement savings plan. Which is it, investing or saving? If I’m investing for retirement, why is it called a savings plan?
Unfortunately, in the investment industry we commonly use the same word to describe many things. “Save” as a verb can mean either
- contribute money to any type of financial account, or
- set money aside without putting it at risk, so it is available when you need it
The first meaning is broader: it can include contributing money to a checking account, a savings account, or your retirement plan. It leaves the question of risk and expected return unstated.
The second meaning is narrow: it specifically means storing money where it is available when you need it. This implicitly excludes risky investments, so it excludes contributing to your retirement plan.
The rest of this post will discuss differences between saving and investing, and how to think about what to do with your next dollar.
Savings accounts and investment accounts
Savings account
A savings account is an account in which you can save money, and you can rely on that money being available in the future, if not immediately then on very short notice. You may or may not hope to earn some interest on that money, but regardless of whether you earn interest you certainly expect not to lose any of the principal you saved. You take for granted the risk of loss is minimal.
While not losing money sounds risk-free, the risk in real (inflation-adjusted) terms is not. If your savings account pays interest, it might not keep up with inflation, so the safety is real in the sense the balance won’t drop, in another sense it is not, because what it can buy may shrink.
Risk: In real terms, having too much in savings relative to investments is a drag on the real growth of your wealth.
Investment account
In an investment account you accept risk on purpose. You are purposely taking a calculated bet that your investment will grow over time above what you could earn reliably in a savings account. In practice, that risk shows up as volatility along the way. Investment risk means you risk losing principal. That’s not something you expect with a savings account.
Risk: Investments entail a risk of loss. Also, having too much money in long-term investments relative to savings can make it expensive to get cash when you need it.
The longer the time horizon, the more investment risk you can tolerate
Time horizon is a spectrum. If you are middle aged, when you contribute to your retirement plan you should understand you will not have access to that money for years – a decade or more. But that is OK: since you’re planning not to need access to that money for a very long time you can withstand the volatility of putting it at risk.
You expect your wealth will grow in the long run specifically because you are willing to endure fluctuations that will occasionally cause your balance to go down.
In between needing your cash now and not needing it for decades is where money market mutual funds serve nicely. If you don’t necessarily need money for a year, but you’re not sure whether you can do without for more than a handful of years, consider these slightly more aggressive forms of savings, which offer higher yields than your bank’s savings account offers. The large mutual fund companies offer money market mutual funds that yield competitive interest rates. Your money might not be available on demand as it is at your bank, but typically you can redeem in a day if necessary.
Investment account choice: retirement plan or brokerage account?
Employer match
Liquidity
An important distinction between investments in a brokerage account and your retirement plan is liquidity risk. Even though you could hold identical assets in your brokerage account and your retirement plan, the brokerage account is more liquid than your retirement plan. If you had to liquidate, you could sell securities from your brokerage account and spend the proceeds within days. Withdraw in a hurry from your retirement account, however, and
- it will probably take longer for the money to reach you, and
- the fees, taxes, and early withdrawal penalties will make the withdrawal more costly than liquidating from a brokerage account.
Taxes
Traditional retirement plans are called “tax deferred” because they shift taxes you pay to the future. Contributions to a traditional retirement plan should reduce your income taxes this year. However, when you eventually withdraw from the plan (hopefully not until retirement) the withdrawals are taxable as ordinary income.
The tax treatment of brokerage accounts is different from that of either traditional or Roth retirement accounts. If your brokerage assets earn interest or dividends, you have to pay income taxes on them. If you sell brokerage assets you held for over a year at a gain, you might have to pay capital gains tax. If you sell at a loss, you might reduce your income taxes. This is not tax advice, so check with your tax advisor for details.
What is the difference between investing and speculating?
Market timing
Timing the market might sound like something overconfident people do, and it is. But selling when you panic is also market timing; it just happens to be fear based. Regardless of the motivation, the cost of not being invested when the market eventually rebounds is too high to give in to your instincts.
Concentrated holdings
Holding a concentrated portfolio has a poor expected long-run payoff. If you look at the statistics on how few professional investors beat the market, best to assume you do not have a reliable edge either. No matter how confident you are in the management of a company you select, no matter how much you know about the company, investing in single stocks is empirically a bad bet. With a single stock (or just a concentrated portfolio) your prospect for long-term growth is dim.
The paradox of diversification is that if you combine several speculative bets, the risk of your overall portfolio is lower than that of the average bet, and your expected compound growth is higher than that of the average investment. When you invest, you harness the power of diversification to increase your expected long-term growth.
Where should my next dollar go? A checklist
