There’s a big difference between saving and investing. But most people, especially young ones joining the workforce, don’t understand this distinction.
In a nutshell:
Saving is simply setting aside money to use at a later date. It’s important to have savings to cover unexpected expenses or to have a cushion in case of job loss, but the money in savings accounts doesn’t grow much.
Investing, on the other hand, is putting money into assets that have the potential to grow in value over time. Stocks, bonds, and mutual funds are all examples of investments. Investing is more complicated than saving, and there’s more risk involved, but it’s also the best way to grow your money over the long term.
If you’re unsure whether you should be saving or investing, a good rule of thumb is to keep enough savings to cover three to six months of living expenses. Then, you can probably invest the rest.
In this article, we will probe further into the various subtle and major differences between saving and investing.
Time Value of Money
When it comes to saving and investing, one of the most important concepts to understand is the Time Value of Money (TVM). Put simply, this is the idea that a euro today is worth more than a euro a year from now. The time value of money is the foundation of savings and investing and is based on the principle of opportunity cost. The opportunity cost is the value of the best alternative that is given up when a decision is made. In other words, the opportunity cost is what you forego when you make a choice.
The time value of money can best be understood through an example. Suppose you are given the option of getting €1,000 today or €1,000 ten years from now. You are most likely to choose €1,000 today because, as the saying goes, a bird in the hand is worth two in the bush.
However, if given the option that you can have those €1,000 today or invest it and have €2,000 in 10 years, you will probably think much harder about which option to choose. If you don’t need €1,000 urgently or in the foreseeable future, then you will seriously consider the second option of waiting 10 years and getting €2,000 instead. While considering the second option, you will also evaluate whether you have any other opportunity to double your money in the next 10 years, and if you don’t, you will most probably go with the second option.
The time value of money is also important to understand because it affects the decisions you make about your money. Suppose you have €1,000 and can either put it under your mattress, put it in a savings bank account, or invest it in a stock or bond:
- If you put the €1,000 under your mattress, it will still be €1,000 when you check under your mattress a year later.
- If you put it in a savings bank account that pays 2% interest annually, it will become €1,020 a year from now because you will earn €20 interest on your €1,000.
- And if you invest in a stock or bond, in a year's time, it can potentially grow and become an amount that is higher than €1,020.
Which of these three options you choose will depend on how much risk you can take and how soon you need the money.
The Inflation: How It Reduces Your Purchasing Power
Inflation occurs when prices rise and purchasing power falls. The value of money decreases over time as prices increase. So, inflation erodes the purchasing power of money, meaning that each euro you have today will buy less than a euro did in the past.
Inflation is caused by a number of factors, including increases in:
- The money supply,
- Government spending, and
- The cost of production.
When the money supply increases, there is more money chasing the same number of goods and services, which causes prices to rise.
Government spending also causes inflation. When the government spends more money than it takes in through taxes, it may choose to print more money to cover the difference. This, again, results in an increase in the money supply and can cause prices to rise.
A lot of times, increases in the cost of production can also cause inflation. When the cost of raw materials or labour goes up, the cost of producing goods and services also goes up. This increase in prices is passed on to consumers in the form of higher prices.
Inflation reduces your purchasing power because your money buys less than it did in the past. Here again, the time value of money concept comes into play. The TVM and inflation are inversely related; inflation reduces your purchasing power. If inflation is 5%, then the same goods and services you can buy for 100 euros today will cost you 105 euros a year from now. In other words, the purchasing power of your money has decreased by 5%.
Inflation is a natural part of the economy, but it can have a negative impact on your purchasing power. To protect your wealth from inflation, you can put the money you have saved in a savings bank account. Or, you can invest your money in assets such as stocks, bonds, or real estate. These assets tend to increase in value at a rate higher than the rate of inflation, which means that your purchasing power will be preserved in the long term.
The Concept of Compounding & Discounting
Compounding is the process of earning additional money on top of your initial investment. This is done by reinvesting your earnings back into your investment, which then allows you to earn even more money. Compounding is often referred to as the “snowball effect” because it allows your money to grow at an increasing rate. The longer you invest, the more your money will grow. This is due to the fact that you’re earning interest on your initial investment as well as on any previous earnings that have been reinvested.
For example, let’s say you put €1,000 into a savings account that has an annual interest rate of 5%. After one year, you will have earned €50 in interest, which will be added to your original investment. Now, in year two, you will not only earn interest on your initial investment of €1,000 but also €2.5 interest on the €50 in interest that was earned in year one. So, at the end of year two, you will have €1102.5. This reinvestment of earnings will continue to compound over time, resulting in additional growth in the value of your investment.
In contrast to compounding, discounting is the process of dividing a sum of money in the future by an applicable discount rate to know its value today. In other words, it’s a way to determine the present value of a future sum of money.
The formula for discounting is:
Today's money = Future money / (1+rate of interest)^n,
where n = investing periods. So, if you would like to have 100 000 euros in 10 years time and the annual rate of interest is 5%, then you will need to invest = 100000/(1.05)^10 = 61, 391 euros today.
There are all sorts of applications for discounting. For example, when you're considering taking out a loan, the bank will discount the future payments you'll make to them, to calculate the amount of money they need to lend you today.
Discounting is also a key part of financial planning. If you're trying to save up for a specific goal, like buying a car, you can use discounting to calculate how much you need to save each month. For example, if you want to buy a car worth €20,000 in 3 years and you can get a savings account with an annual interest rate of 5%, you would need to save only €514.2 per month. However, if you save on your own by keeping the money at home, then you will need to save €20,000 / 36 = €555.55 per month.
Compounding and discounting play a major role in saving and investing because they are used to determine the future and present value of money. By understanding how compounding and discounting work, you can make better financial decisions that will lead to a more secure future.
What is Savings?
Savings is money set aside in a risk-free account. The main purpose of saving money is to have funds available for future goals. This could include buying a car, a child’s education, or a rainy day fund. Another purpose of saving is to protect money from value loss. This is important in times of inflation, when the purchasing power of a euro decreases.
Why Save?
There are many reasons to save money. One is to have a cushion in case of an emergency. Unexpected expenses, like a car repair or medical bill, can pop up at any time. If you have savings, you can cover these expenses without going into debt. Another reason to save is to reach financial goals. Do you want to buy a home, start your own business, or retire early? Savings can help you achieve these goals.
There are a variety of savings instruments and products available, including bank savings accounts, term deposits, which are also called certificates of deposit, and bonds:
- Bank savings accounts offer a safe place to store your money, and they usually offer a small interest rate.
- Term deposits, or certificates of deposit, are a type of savings account that offers a slightly higher interest rate, but you agree to leave your money in the account for a set period of time.
- Bonds are a debt investment, and they offer interest payments at regular intervals, which you can collect or reinvest.
Saving money regularly is always a good idea for any individual who works. By saving money in the present, you can ensure that you have the money you need in the future. The best way to save money is to start early and contribute to your savings regularly. There are many different ways to save money, and the best way to save will vary depending on your individual circumstances.
What is Investing?
Investing is simply the act of putting your money into something with the expectation of earning a return. The most common way to do this is by buying stocks, which are shares of ownership in a publicly traded company. But there are also other options, like mutual funds, exchange-traded funds (ETFs), and alternative assets like REITs and fractional ownership of art or collectibles.
The key to successful investing is understanding the risks and rewards involved. With any investment, there is always the potential for loss. But the potential for gain is what makes investing so attractive. The higher the risk, the higher the potential reward. That’s why it’s important to carefully consider your goals and risk tolerance before deciding how to invest your money.
Stocks are a good example of a high-risk, high-reward investment. They offer the potential for big gains but also come with the risk of substantial losses. Mutual funds and ETFs are generally considered to be lower-risk investments, as they offer diversification and often have built-in safeguards against loss. But even these investment vehicles come with some degree of risk.
Alternative assets like hedge funds and private equity are even riskier but can also offer the potential for much higher returns. These types of investments are not for everyone and should only be considered by those who are willing and able to stomach the potential for loss.
No matter what type of investment product you consider, it’s important to do your homework and evaluate the risks and rewards involved. With a clear understanding of the potential ups and downs, you can make informed decisions that are right for you and your investment portfolio.
Savings Versus Investing Comparison
When it comes to financial planning, many people debate whether it’s better to save or invest their money. The truth is, both are important! Depending on your goals, you may want to do both, or you may want to focus on one more than the other.
Here’s a breakdown of the key differences between saving and investing and how to decide what’s right for you:
The key difference between saving and investing is that with savings, you are putting your money into a low-risk account with the goal of keeping it safe and growing it slowly over time. With investing, you are putting your money into higher risk assets such as stocks, bonds, or real estate with the goal of earning a higher return.
Both saving and investing have their pros and cons. Savings is great for short-term goals or emergencies because it’s a low-risk way to grow your money. Investing is better for long-term goals because you have the potential to earn a higher return.
The best way to decide whether to save or invest is to look at your financial goals and time horizon. If you have a short-term goal, such as saving for a down payment on a house, you may want to focus on savings. If you have a long-term goal, such as retirement, you may want to focus on investing.
Of course, you don’t have to choose one or the other! You can do both, and many people do. If you have a mix of short-term and long-term goals, you may want to keep some of your money in savings and some in investments.
The important thing is to create a financial plan that meets your needs and helps you reach your goals. If you’re not sure where to start, a financial advisor can help.
Conclusion
The question of savings vs investing can be a difficult one, especially when it comes to long-term financial goals. There are a few things to consider when making the investing vs savings, such as your time horizon and financial goals.
If you have a short-term goal, such as saving for a down payment on a house, you will want to focus on saving. This is because you will need the money sooner, and you don’t want to risk losing any of it. Investing can be a great way to grow your money, but it is also more volatile.
On the other hand, if you have a long-term goal, such as retirement, you will want to focus on investing. This is because you will have more time to weather any market ups and downs, and you can afford to take more risk.
Ultimately, the decision of savings vs investing must be based on your financial goals and time horizon. If you have a short-term goal, saving is the best option. If you have a long-term goal, then it is worth thinking about investing deeper.
