Most of us innately know that saving and investing are not the same, but do we understand the difference? Because clarity in this distinction can greatly impact one’s financial well being, realizing these difference is vital. The key is in two words: risk and liquidity.
Savings are low risk funds that must be liquid (available) when you need them. The purpose of saving money is so you can have it for a specific purpose within a short time frame.
Investments, on the other hand, are for wealth building, and will not be needed for many years. Yes, investments do involve greater risk, but, investments also yield much greater returns when left alone long enough to ride out the turbulence of the stock market.
Examples of savings
When an emergency happens, the money is needed immediately. The emergency fund, therefore, should be in a very boring account, such as a Savings Account or Money Market Account. One could also consider an online high interest account, as long as the funds are easily accessible. Its purpose is not to make a bunch of money; it is there for emergencies.
You DO save up and pay cash for your cars, don’t you? This money should be saved, not invested. Why? Because you don’t want to take the risk of a market plunge just when you are ready to buy.
Anything else you will need to pay cash for
What are you saving for (notice the word “saving”)? A home improvement (or repair), a riding lawn mower or a new computer are all examples of saving: you will need a set amount on a set date.
College Funding (sort of)
Should college funding be an investment or saving? It depends on how soon Junior is going to be entering college. If college is 18 years away, the money should be invested (make sure you use an ESA or 529 plan to get all of the tax breaks). But what if college starts four years from now? You don’t want the risk of your investments tanking just when that first tuition payment comes due. The choice is yours, but I think you should be moving those funds to a less risky vehicle (maybe even a savings account) as the time of need approaches.
Examples of investments
Yes, retirement is the big one and retirement funds should definitely be considered investments. Such funds should be rebalanced annually or even bi-annually, but you basically leave them alone and don’t worry about checking the stock returns by month. However, like college funding, the retirement nest egg should be made safer as the time of need draws closer.
Starting a business
If you have a long range plan to start up a business (say 10 to 20 years from now), you should be investing to achieve the nest egg needed.
Breaking it down
The difference between investing and savings is really quite simple. If you are going to need the money in the near future, save it. If you aren’t going to touch the money for a longer time frame, invest it. The trick is defining this time frame. Financial guru Dave Ramsey uses five years as his criteria. His rationale is that the stock market has historically made money in 93% of the five year rolling time frames and in 100% of the rolling ten year periods. Most of us are aware that the recent recession changed those percentages, and I heard Dave Ramsey recently say that the stock market has made money in 100% of all rolling fifteen (no longer ten) year periods. However, as far as I know, Dave still uses the five year criteria to distinguish saving from investing.
What do I think about the five year guideline?
I am OK with it. If I know I will need to tap the money in five years or less, I consider it savings. Our emergency fund and car fund are both in Money Market Savings Accounts. On the other hand, if I am not planning to touch the money for longer than five years, I invest it. Our traditional and Roth IRA’s are examples of our investments.
One could also have a hybrid investment fund. An example of this would be flipping a house. This is clearly an investment, with money tied up in the house. However, when the house sells, keep this money quite liquid and available (think savings account) so you can be poised to buy another flip house. I label this hybrid, because you would at that time have an investment that you’re treating like savings.
How about you? Do you have a clear guideline to distinguish saving from investing? What is that guideline?