Key Takeaways
- The best financial plans reflect sequential saving and investing initiatives.
- Saving facilitates near-term security and flexibility via an emergency fund.
- Investing facilitates long-term wealth accumulation.
- There are various savings vehicles and investment instruments available in the market. Understanding them is critical to boosting your financial literacy and achieving your goals.
Saving and investing are equally important, sequential aspects of a financial plan. Saving comes first. It forms the foundation of your plan, offering both financial security and flexibility, with investing taking a secondary role. It is a long-term endeavor focused on accumulating wealth in a risk-conscious manner.
A successful financial plan entails transitioning from saving to investing at the appropriate time. This guide outlines when the time is right and how to optimize your saving and investing activities.
Striking the Right Balance Between Saving and Investing
The most robust financial plans consist of both savings vehicles, such as high-yield savings accounts, money market accounts and certificates of deposits (CDs), and long-term investments, such as bond funds, stock funds and annuities.
Everyone should establish an emergency reserve before beginning an investment program, but the optimal size of the reserve varies from one person to the next. For many, a savings reserve amounting to six months of living expenses is adequate. However, some people maintain smaller reserves, and others maintain larger ones.
Regardless of the size of the reserve, the rationale is the same. If you have a financial emergency, such as losing your job or suffering an uninsured loss, a savings reserve provides the liquidity necessary to ride out the storm. Without it, you could be forced to incur costly debt or sell long-term investments at an inopportune time.
| Saving | Investing | |
| Example | Opening a high-yield savings account | Buying a diversified index stock fund |
| Goal | Covering living expenses in the event of an emergency | Generating long-term wealth |
| Risk | Low | High |
| Returns | Low | Potentially high |
| Accessibility | High | Low |
The table above does a nice job of contrasting saving and investing. However, some of the vehicles used to save and invest are complex, and some exhibit attributes that can be categorized as both savings-oriented and investing-oriented. Let’s take a deeper dive to clarify things.
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Saving
We’ve all heard the following money-saving mantras:
- A penny saved is a penny earned.
- Save before you spend.
- Every little bit helps.
- Pay yourself first.
Yet, it appears many people choose not to, or are unable to, so it’s wise to heed this advice. According to the Federal Reserve, many Americans would be unable to cover an unexpected $400 expense up front. 25% would have to use a credit card or borrow money from family or friends, and another 13% would have no means to cover the expense at all.
The Federal Reserve’s 2022 Report on the Economic Well-Being of U.S. Households also states that nearly 28% of non-retired adults don’t have a retirement savings plan in place. Many Americans believe they cannot contribute even a small amount toward retirement.
There are a myriad of factors underlying these startling statistics, including low levels offinancial literacyand underdevelopedbudgeting skills. This guide is not a remedy for these issues, but it can help you better understand the importance of saving and the tools available to you.
Pros and Cons of Saving Without Investing
Saving is prudent and essential for everyone, regardless of economic status. As a result, establishing a “saving pros and cons” list only makes sense in the context of saving to the exclusion of investing.
Prominent advantages and disadvantages are as follows:
Pros
- Safe
- Guaranteed interest
- Easy to establish
- Highly accessible
Cons
- Low-yield
- Susceptible to inflation
- No tax-advantages
- Potential lock-up periods and account minimums
Saving is a sure-fire way to increase your financial security and earn a guaranteed rate of interest. However, the yields offered on savings vehicles are significantly lower than those achievable via long-term investments. Oftentimes, savings yields may not even keep pace with inflation, a situation that can result in reduced purchasing power and a busted budget.
These drawbacks are the reason the strongest financial plans consist of both savings vehicles and long-term investments. This pairing produces the optimal combination of safety/liquidity and return potential.
Savings Vehicles
A variety of instruments can be used to house your savings. Choosing the right one entails making sure your funds are safe, accessible and guaranteed to earn a competitive rate of interest.
Types of Savings Vehicles
- Traditional savings accounts
- High-yield savings accounts
- Money market accounts
- Treasury bills
- CDs
Not all savings vehicles are created equal. For instance, high-yield savings accounts typically offer much higher interest rates than traditional savings accounts, but they usually require higher minimum deposits. In many environments, the most competitive CD rates trump high-yield savings rates, but penalty-free CD withdrawals are not permitted.
Given the differences, it can make sense to own more than one type of savings vehicle. For example, if you maintain an 18-month emergency fund, you might opt to put six months’ worth of savings into a fully-accessible, high-yield savings account and the other 12 months of savings in a higher-yield, 12-month CD.
How Much Money Should You Keep in Savings?
Financial advisorssuggest maintaining at least six months of living expenses in an emergency fund. They also encourage people to begin saving for retirement as early as possible and to contribute the maximum permissible amount to their 401(k) or other qualified retirement plan, especially if an employer match is offered.
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Investing
If you have an adequate liquidity reserve in place and excess funds to deploy, it is time to implement an investment program. The first step in the process is to formulate investment objectives that align with your risk tolerance, which is largely dependent on your investing time horizon.
This can be a challenging exercise, especially for novice investors. As a result, leveraging the assistance of a fiduciary financial advisor or robo-advisor is highly recommended.
The former solution makes the most sense for individuals with relatively large portfolios and a need for holistic financial support. The latter solution, which utilizes computer algorithms to allocate assets, is best for cost-conscious investors in the early stages of their investment journey.
Read More:What Is a Dividend?
Pros and Cons of Investing
The primary advantages of investing are the opportunity to grow your principal and earn passive income. Unfortunately, these benefits come with the possibility of losing some or all of your principal.
In addition to the downside exposure, many investment instruments are inherently complex. This necessitates a rudimentary understanding of key investment concepts.
The Financial Industry Regulatory Authority (FINRA) suggests all investors understand the following concepts:
- Investment performance evaluation
- Asset allocation
- Diversification
- Portfolio management
- Investment risk
This goes for investors that manage their own portfolio and those that outsource the responsibility to advisors or fund managers. Everyone needs to maintain a basic understanding of how they invest their money.
Investment Instruments
The universe of investment instruments available to retail investors is incredibly broad. With a brokerage account, you have the ability to invest in thousands of individual stocks and bonds.
A more prudent approach (especially, for inexperienced investors) is to invest in low-cost, fund-style vehicles, such as index funds and exchange-traded funds (ETFs), to gain diversified exposure to desired asset classes.
The optimal asset allocation depends on your investment objectives and risk tolerance. Most people strive to achieve some combination of preserving principal, generating income and growing capital. Highly risk-averse individuals should favor preserving principal and generating income, while less risk-averse individuals should favor growing capital.
A brief list of the types of funds (low-risk to high-risk) that could be used to construct an investment portfolio is below. Actual fund examples are provided in parentheses.
- U.S. intermediate term, Treasury securities funds (SPTI)
- U.S. broad-market, investment grade bond funds (BMOAX)
- U.S. broad-market stock funds (VTI)
- International developed markets stock funds (IEFA)
- International emerging markets stock funds (VWO)
In addition to the asset classes noted, some investors may find it beneficial to allocate some money to alternative investments, such as real estate investment trusts (REITs), floating-rate debt funds or precious metals funds. Others may wish to incorporate fixed annuities or indexed annuities into their investment plans.
The optimal mix of assets can vary widely from one individual to the next. Again, this is a complicated determination that usually warrants expert guidance.
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How Much Money Should You Invest?
Once your liquidity reserve is established, you should invest excess money in accordance with your personalized, long-term investment strategy. A financial advisor or robo-advisory platform can help you do this.
Regardless of the nature of your investment strategy, financial experts recommend remaining fully invested across all economic cycles, taking care to periodically rebalance your portfolio back to your long-term asset allocation targets.
Read More:Investing for Beginners
Frequently Asked Questions About Saving vs. Investing
How much money should I contribute to saving versus investing?
Everyone should establish an emergency reserve before beginning an investment program. However, the optimal size of the reserve varies from one person to the next. Generally, a reserve amounting to three to 12 months’ worth of living expenses is appropriate. However, some people maintain larger reserves.
Money saved in excess of your liquidity reserve should be invested in accordance with a long-term strategy that reflects your risk tolerance. Failure to do so is likely to result in inadequate retirement savings and elevated longevity risk, which is the possibility of outliving your savings.
When should I begin investing?
You should strive to invest as early and for as long as possible to capitalize on the power of compounding interest. However, as noted above, establish an adequate liquidity reserve before launching an investment program.
Editor Bianca Dagostino contributed to this article.
