Saving vs. investing – the age old question. Which makes more sense for your long-term financial future?
Both saving and investing come with their own risk-reward profiles, and the best strategy varies from person to person. Sometimes, it makes sense to change course due to the changing external factors of life.
Here, we’ll explore the profiles of both for your consideration to help you better understand the merits and drawbacks.
Macroeconomics of saving vs. investing
Context is key.
Macroeconomics (i.e., the ‘big picture’) are important considerations when comparing saving vs. investing.
Some key concepts worth factoring into your decision making are inflation and the dollar’s purchasing power.
They are functions of each other. They have an inverse relationship. When inflation is up, the dollar’s purchasing power goes down. That’s because when inflation is high, the prices of goods and services goes up. You have probably noticed an increase in the cost of many regular expenses – your groceries, a tank of gas, perhaps your rent. This is the product of inflation.
Say every year, you allocate $100 to take your friends out to the movies while they’re all in town for the holidays. You’ve been doing it for decades.
In the year 2000, when movie ticket prices were $5.66, you would have been able to bring along 17 friends. In 2020, when the national movie ticket price averaged $9.31, you would have to make a few cuts, because now, you can only afford 10 tickets with the same amount of money.
You’re still putting up the full $100 – but what you can buy with that money has gone down.
While there are several economic indicators used to measure inflation rates, the one that is generally most significant for average Americans the CPI index. The CPI index measures a basket of consumer goods – from food, to gas, to rent – to estimate the increase in the overall cost of living.
As last reported by the Department of Labor, the CPI index has increased by 5.4% for the 12-month period ending in September 2021. That means life is about 5.4% more expensive than it was a year ago.
With that, we have some framework in which we can better assess if saving or investing makes more sense.
The world of finance, proper due diligence doesn’t only evaluate potential gains and losses. It’s also about risk management.
Risk management considers the probability of different outcomes.
You likely weigh out the probabilities of different outcomes often in your daily life. For example, you look up a car mechanic in your area on Yelp! You find two – one that has numerous 5-star glowing reviews, and another with numerous 1-star complaints. The former is more expensive.
But you decide to do business with them despite the higher cost, based on from pervious customers. You are betting that the lower the risk of getting ripped off or having a faulty repair done – worth the extra cash.
This assessment of likelihood of desired outcome is arguably more important than determining potential outcomes. After all, most people would take 50-50 odds of winning $1,000 than a one in a million chance of winning a million dollars.
Savings: A guaranteed loss
For most people, keeping their money in a savings account feels safe. It is safe in that money kept in a savings account is secure and insured.
Additionally, money kept in a savings account is essentially instantly accessible in times of need. If a financial emergency required $5,000 to be paid on the spot, having the money in a savings account readily available can prevent you from having to put the expense on credit and pay interest rates in the 20%+ range.
But by other measurements, it’s quite unsafe. With inflation rates topping 5% in just one year, the value of your money it is a guaranteed loss. In other words, there is a 100% chance that the purchasing power of your savings accounts will decline as inflation goes up.
With inflation rates at historical highs and showing no signs of subsiding, it’s critical to understand that money sitting in a bank savings account is losing value.
If your bank pays you an annual interest rate, that does help a little. But with most bank savings accounts offering around 0.5% interest annually, it is hardly offsetting about 10% of the value lost to inflation.
In a nutshell, given the current rate of inflation as the cost of living goes up, the risk-reward profile of keeping money in a savings account breaks down to:
- Loss potential: Very high probability
- Loss max: Capped at the rate of inflation (-5.4% in purchasing power for 12-month period ending in September 2021.)
- Gain potential: Very low probability
- Gain max: Decline in the cost of living
- Other considerations: Easy access to funds
Investing: A risk of loss, and potential to gain
The alternative way to store your hard-earned dollars is in the form of investments.
With a savings account, you can, with a fair degree of certainty, know what to expect.
Investing on the other hand has many more possible outcomes, each with its own risk-reward profile.
However, with investing, there is a much higher probability of staying ahead of inflation in the form of returns. If a $100 investment produces 6% in returns for in a year, the extra $6 in profit fully offsets the purchasing power erosion effects.
Funds held in investments aren’t any more protected from inflation than those held in savings accounts. But unlike money kept in savings accounts, there is potential to gain on investments – potential that essentially does not exist with savings accounts.
No investment is risk free
As a general rule of principal, the higher the risk, the higher the potential reward. Traditionally, the safer the investment, the lower the reward potential. The higher the risk, the higher the potential returns – but also a lower probability of hitting those returns, and a higher possibility of losing your investment.
For example, odds of ‘losing it all’ on blue chips stocks aren’t high. Companies like Microsoft and Johnson & Johnson are likely to survive even sharp market corrections.
But they aren’t likely to top the potential gains of a unicorn penny stock that really hits it big. That being said, for every unicorn penny stock investor that hits it big, there were thousands of others who took losses on penny stocks.
Every investor has to decide their own risk tolerance.
In sum, the risk reward profile of investing:
- Loss potential: Very low–very high (depending on investment, e.g., blue chips vs. penny stocks)
- Loss max: Capped at initial investment (unless engaging in short selling)
- Gain potential: Very low–very high (depending on investment, e.g., blue chips vs. penny stocks)
- Gain max: Uncapped; infinite potential
- Other considerations: Lower liquidity. Some investments, like stocks and crypto add a 1–3 business day delay to access your funds; alternative investments, such as real estate or commodities could make accessing your funds a long and involved process.
Saving vs. Investing
While everyone’s financial situation is different, with inflations eating away over 5% of the dollar’s purchasing power every year, keeping money in a savings account is in effect an almost certain loss.
Investing on the other hand, opens up the possibility of staying ahead of inflation.
For example, HappyNest is an REIT portfolio you buy into for just $10 per share. On average, the quarterly dividend payments average 6% a year, topping inflation’s erosion on your purchasing power.
In addition to the quarterly dividends, as the properties in our portfolio gain value, your investment does as well. As such, you not only keep pace with inflation and preserve your nest egg’s purchasing power, you also can gain value on your capital while it is invested.
Remember: It’s not really about movie tickets, rent, the price of gas, etc.
Most Americans work for wages or salaries. They exchange their time for money.
In a savings account, time works against you. It erases hours you already clocked in – hours away from your family, your friends, your hobbies, your pets. Smart investing makes time your friend, opening up the opportunity to buy some of it back in the future.
Because it is time – not money – that is life’s most precious, limited and valuable asset.