Many of us envision savings accounts and stock investment accounts as means to set aside money and hopefully earn a little on the side.
There are, however, crucial differences in the saving and investment definitions — and they may be causing some Americans to favor one over the other.
The Motley Fool reports that 71% of Americans have savings accounts, financial vehicles that don’t generate a ton of extra income. But on the other hand, Forbes reports that only 55% of Americans hold shares in stocks, which are riskier but carry a greater profit potential.
What are the deeper differences between the two? Can your finances benefit from a healthy relationship between saving and investing?
Savings vs. Investments
Both savings and investments play meaningful roles in maintaining a healthy economic profile. Many people unschooled in the ways of finances confuse the two words or use them interchangeably. But there are distinct differences between the two.
Saving Money
Saving money can be thought of as a security blanket or the foundation of a person’s finances. It’s simply taking some of what you earn and stowing it away.
True, you can just save your extra cash inside your mattress or in a bunch of Mason jars. Most normal people, however, open savings accounts at banks.
Unlike debit cards or checking accounts, most savings accounts earn interest on the balance, compounded daily or monthly. The interest rate varies from bank to bank. Some banks require a minimum balance on a savings account.
The main point of a savings account is to stash money away for future needs or emergencies. It’s primarily a way to ensure that you’ll have enough money for whatever emergencies come up or to have a certain amount ready for big-ticket purchases. A good bank for savings will be FDIC-insured so your money is protected, while also offering a high annual percentage yield so your account can earn maximum interest.
Investing Money
Investing is like savings in that you’re putting money in a financial account for the future and basically leaving most of it alone. The big difference is in how much return an investment account holder aims to earn: More — potentially much more.
With investing, your money doesn’t just sit idly in a bank ledger. There’s a transaction involved. If you invest in stocks, you pay money to a brokerage and get ownership in a public company. As the company profits and its shares go up in value, so do your holdings.
In addition to stocks, mutual funds, and exchange-traded funds (which are vehicles for investing in multiple stocks at once), other investment strategies include bonds, T-bills, precious metals, real estate, IRAs, and cryptocurrency.
Savings vs. Investment Economics
One big difference between saving and investing is how the gains are accounted for and distributed.
With a savings account, your interest returns are essentially cold, hard cash. If you leave your savings untouched and don’t add or take out any money, you’ll receive a modest bump in your account balance every week or month. The interest keeps accumulating, minus any management fees your bank charges.
With investments, your gains are only on paper. When you see that one of your stocks has gone up in value, you’ll notice a gain in your portfolio. But you don’t actually realize any of that profit until you sell the stock.
Savings vs. Investment: Risk Tolerance
Perhaps the most striking difference between savings and investment is the level of risk the account holder takes on.
Savings accounts are about as risk-free of a financial vehicle as you can get. You’re not going to lose any money while it’s in the bank because your deposit is federally insured. It only goes down when you withdraw money from it (or the bank charges you fees). You’ll be safe and secure.
Investments, on the other hand, are inherently risky. The stock market is known for its volatility. Share price fluctuation is a fact of life. There are so many factors that play into the rise and fall of a company’s fortunes that it’s essentially unpredictable.
The most serious and successful investors have strong stomachs and wills of iron. The risk is enough to scare off nearly half of all Americans from the stock market, as we mentioned at the beginning. But why do others put themselves through the wringer to hold stock?
Savings vs. Investment: Rate of Return
Put simply, the chances of a well-run stock portfolio returning bigger profits is greater than a savings account doing the same.
The stock market’s average rate of return is about 10%. It’s remained at or near that level for about 100 years. Some years are much better than others, of course; in 1995, the S&P 500 returned more than 34%, but in 2008, it skidded to a 38.5% loss. But the up years greatly outnumber the down years over that century.
What does a savings account return in interest every year? Right now, the average percentage yield (APY) is about 0.04%. For example, if you put $10,000 in a savings account that compounds interest monthly and don’t add anything to it, after one year, you’ll earn a whopping $4 in interest. Adjust your glasses if you have to.
Granted, that wasn’t always the case. Before the Great Recession of 2008, there were plenty of savings accounts to be had that returned more than 3% a year. But when the bottom fell out, the Federal Reserve lowered interest rates to near-absent levels, so the banks had to follow suit. Since then, there have been a few attempts to raise rates, but mostly, they’ve remained the same.
There’s another option that earns significantly more: A high-yield savings account. These vehicles offer rates around 20 to 25 times higher than traditional accounts.
High-yield savings accounts are typically offered by online banks like Citi and Nationwide, which don’t offer a lot of other regular banking services. They’re also federally insured so you’ll never lose your money, even if the bank fails. While their rates still aren’t as eye-popping as average stock market returns, they are noticeably higher than regular savings accounts.
Right now, the leading high-yield savings account banks offer APYs between 0.45% and 0.57% a year. So that same $10,000 we just mentioned above would return $57 after a year of compounding monthly. That’s significant, especially with higher account balances.
The relationship between savings and investing is perhaps the clearest example of the risk/reward ratio in the financial industry. Savings accounts are low-risk strategies that will keep your money safe but won’t result in skyrocketing returns. Stock investments will always be associated with higher risk, but the potential for great profits is much higher, as well.
With that being said, some stocks are far safer than others. Massive corporations that have been around for a while, weathered recessions, and continue to thrive and corner their markets generally don’t lose their investors a lot of money. More than that, they will usually bring in a bit of a profit that’s still bigger than interest returns on savings accounts.
The average one-year return for companies on the Dow Jones Industrial Index — the largest of the large — currently stands at a little more than 2.5%. For the S&P 500, that figure is 3.4%, and for Nasdaq, it’s 2.94%. Every company is different, of course, and some will suffer losses in certain years. But even low-risk stocks stand to earn more returns than any savings account.
Savings vs. Investment Economics: What Forces Affect Markets the Most?
Another big difference between savings accounts and investments is the type of financial factors that influence the returns they generate. In a general sense, both vehicles are affected by overall economic conditions, whether that is prosperity or recession. They’re also tied to the concept of supply and demand. But in many ways, they’re independent of each other.
Savings Account Interest Rates
Savings account interest rates are set by the banks that issue them. It’s all connected to the concept of lending money.
When you open a savings account, you’re actually loaning the bank more money to work with so they can issue loans and credit. They pay you interest for your trouble, although it probably doesn’t take a lot of work on your end.
The bank needs to make money on the loans they give out. So their savings account interest rates must be lower than the interest rates they charge on loans. When they need to attract more money to keep their lending business intact, they’ll increase the interest on savings accounts. If they’re doing well in the lending department and not competing that hard for business, they’ll lower the rates to stay balanced.
Banks also place heavy emphasis on the interest rate set by the Federal Reserve. It’s used generally as an economic indicator for the future, so most banks follow its lead to some extent.
Investment Return Rates
Returns on investment in stock holdings can be influenced by many factors, both directly and indirectly. But the basic reason for a stock price going up or down relates to trading volume. If more investors are buying stock, the share price will go up. If investors are unloading shares in a certain company, the stock price goes down.
What spurs investors to buy or sell shares? Just about anything. Quarterly and annual earnings reports, company leadership changes, business sector booms or busts, global news, sudden waves of investor sentiment, analysts on TV cable business shows — all of these factors and more influence trading volume.
That’s why it’s important to be analytical about investments and rely on data as much as humanly possible. The volatility of the stock market can be set off by virtually anything. Savings accounts tend to be a little boring, which is why some people like them.
Savings vs. Investment: Which One’s For You?
When it comes to personal financial vehicles, there’s no reason for exclusivity. It makes a lot of sense to have both a savings account and an investment account.
The purpose of having a savings account is to have money on hand for emergency purposes or major purchases down the road. It’s safekeeping. The primary goal in having a savings account is simply to not lose money and to add to your cash reserves as you see fit. That’s why the interest rates are, for the most part, unexciting.
The purpose of an investment account is to generate some kind of income. You invest in a company because you believe they’re going to be very profitable someday soon and you want to have a piece of that success. If you do the job right, the returns you gain from stock investments will far outpace the interest you’re earning on your savings account. But there’s a risk that they won’t.
The relationship between saving and investing is a little like that of a bank and a casino. Banks need to make money, but they’re more like a public utility than a business — they just keep your money secure.
Casinos, on the other hand, are places where people go to get more money. Every once in a while, someone will strike it big on a slot machine and become an instant millionaire. On the other hand, more seasoned, experienced, and intellectual gamblers may win a little bit at a time, but more often.
There’s no reason a town can’t have both a bank and a casino. There are several levels of difference between saving and investing, but both can co-exist peacefully in your financial profile.
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