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We’ve all heard the phrase “saving for a rainy day,” but do we truly understand the difference between saving and investing? While both involve putting money aside for the future, they are very different approaches. The key difference comes down to risk versus reward. And understanding how this plays out is essential when deciding whether to save or invest your money.
While both savings and investments aim to grow your money for a specific purpose, the difference lies in the potential reward and the level of risk you’re willing to take in order to achieve that reward.
What are savings?
Savings are typically used for short-term goals. Maybe you’re saving for a new car, a holiday, or an emergency fund. The goal is to keep the money safe and accessible, but with the trade-off of lower returns. Savings tend to be low risk and can easily be accessed when needed.
For most people, savings are held in a bank account—either a regular savings account, an easy access account, or a fixed-term account. With a savings account, you earn interest on the money you deposit. The longer you commit to locking your money in, the higher your interest rate may be. However, the more flexibility you require, the lower the return will be.
While savings are relatively safe, they do come with some risks. The most obvious risk is inflation—if the inflation rate is higher than the interest rate you’re earning, the purchasing power of your savings could decline over time. For example, if inflation is 11% and your bank pays you only 3% interest, your money will lose value over time.
On the plus side, in the UK, savings up to £85,000 per bank are protected by the Financial Services Compensation Scheme, so you’re generally safe from losing your money if your bank goes under. Still, there’s always the risk of institutional failure, as we saw with Lehman Brothers in 2008.
What are investments?
Investments are typically made for long-term goals. If you’re aiming to build wealth over time, perhaps for retirement or a future property purchase, investing may be the right choice. Investing usually involves higher risk than savings, but the potential rewards are much greater.
When you invest, you are placing your money in investment vehicles, such as Stocks and Shares ISAs, Investment Bonds, Pensions, or General Investment Accounts. These allow you to hold various assets, such as stocks, bonds, property, and equities. The idea is that, over time, these investments will grow in value and outpace inflation.
Each investment vehicle and asset class carries a different level of risk. For example, equities (stocks) tend to be the riskiest, but they also offer the highest potential returns. Bonds or fixed interest investments carry lower risk but also lower potential rewards. Property investments might offer moderate risk and return.
If you dive deeper into these assets, you’ll see that individual companies or properties also come with their own risks, so diversifying your investments is key.
The Risk Reward Trade Off
So, what does this all mean? In a nutshell, savings are safe, but offer lower returns, whereas investments carry more risk but offer the potential for higher returns. A traditional rule of thumb is:
- Cash savings are the safest, but offer the lowest returns.
- Bonds and fixed interest come next, with moderate risk and moderate returns.
- Property can offer higher returns, but also brings the risk of market fluctuations.
- Equities (stocks) carry the highest risk, but have the greatest potential for high returns.
The more risk you’re willing to take, the greater the reward you can hope to earn. But remember, higher risk means a higher chance of loss as well.
Which Is Right for You?
Most people need a combination of both savings and investments. Savings are great for short-term goals and emergencies, ensuring you have cash available when you need it. On the other hand, investments are more suitable for long-term goals, such as building wealth over 10, 20, or 30 years.
Before you start investing, it’s crucial to have a rainy day fund in place. This will ensure you don’t need to dip into your investments if an emergency arises. Once your emergency fund is established, you can begin looking at investments that match your long-term goals.
Your approach to investing will also depend on your timeframe. If you’re nearing retirement, you’ll likely need to invest differently than someone in their 30s or 40s. Older investors may want lower-risk options as they approach their goal, while younger investors can afford to take on more risk with a longer-term horizon.
In Summary
- Savings are great for short-term, low-risk goals where you need easy access to your money.
- Investments are suitable for long-term goals where you’re willing to take on more risk for the potential of higher returns.
It’s important to understand the risks and rewards associated with each and to plan your financial strategy based on your goals, timeframe, and risk tolerance.
In our next blog post, we’ll dive deeper into the world of investments, exploring different investment vehicles and how to start investing for your future.