- Savings accounts and investing accounts serve different purposes
- Savings accounts are for saving for shorter-term goal
- Investments accounts hold your portfolio of stocks, bonds and cash
- A diversified portfolio can help you manage your risk
Saving and investing — they’re both critical to achieving your financial goals. They both require you to put money aside, but for very different purposes.
If you’re confused by the difference, you’re not alone. Most people in the U.S. don’t save enough, according to think tank Economic Policy Institute. And only half invest, according to a recent report from polling organization Gallup.
We explain the key differences between saving and investing and how you can allocate your money in a way that matches your long term goals.
What are “savings?”
Most people with a salary receive a bi-weekly or monthly paycheck from their job. This income is used to acquire goods or pay for services like food, transportation, utilities as well as leisure activities. The money left over after you subtract all your expenses from your income are your savings.
People save money for lots of different reasons. People save to make sure they have enough funds for an upcoming event or expense. Christmas presents, next year vacations, funds for an emergency, buying a new car or an unforeseen expense. This is when having a savings account comes in handy.
What is a savings account?
A savings account is an account that allows you to securely store the savings previously discussed in the form of cash while at the same time earning a small interest on the deposits you keep in there.
How do savings accounts work?
When you deposit money in a savings account, you are essentially giving the bank a loan. The bank then uses that money to lend to other individuals or institutions. In essence, a bank acts as intermediary for people who have excess cash (aka savings) and people who need cash for different reasons like a mortgage on a house, a car loan, expanding a business, etc.
The key benefit of a savings account is that your money is stored risk-free with the guarantee that you will not lose any of your funds for up to $250,000. This is because accounts with most banks are provided insurance through the Federal Deposit Insurance Corporation (FDIC), a U.S government corporation in charge of supervising that U.S banks use funds deposited by customers in a safe and sound manner.
See for yourself. Next time you go to your local bank branch, you’ll likely notice a disclaimer that says the bank is FDIC insured. This means what we discussed previously, that your money is protected for up to $250,000 per account.
A savings account is not a checking account
A savings account is not to be confused with a checking account. A checking account is usually a place to store the money you’ll soon spend as part of your regular expenditures. Your savings account on the other hand, is usually used to store the money for expenses that are not immediate but also not too far ahead.
A good way to think about a savings account is as an account for money you want to use in less than 1-2 years, though these dates only depend on your personal circumstances.
Cash kept in a savings account is usually not meant to be as easily accessible as money kept in a checking account. In fact, most banks will charge a fee if you make more than six withdrawals or transfers from a savings to a checking account per month due to federal regulation.
Should I keep all my money in a savings account?
As we mentioned earlier, saving accounts are great for keeping the money you are looking to spend in short to middle term (next year vacations, new car, emergency fund, etc). If you want to set aside money for longer-term financial goals like retirement, saving for a child's college education, the down payment on a house, etc, saving accounts may not be beneficial. In fact, it could have a negative impact on the money you set aside for the long term.
Can I lose money in a savings account?
The funds on a savings account are guaranteed by a bank. However your money is subject to lose purchasing power by sitting in your savings account because of something called inflation.
“Losing purchasing power” means losing the ability to purchase the same amount of goods and services as before. Inflation is the increase in price of of goods and services over time.
While many economists argue steady inflation is good for the overall growth of an economy, inflation can actually cause cash balances in a savings account to lose purchasing power. Inflation causes the price of goods and services to increase over time. This means the cash balance in your savings account would purchase less goods and services in the future due to price increases.
This affects savings accounts because they usually do not keep up with the rate of inflation.
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Saving accounts and inflation
For example, the 2017 average savings account interest rate in the U.S is roughly .06%, with some banks offering as much as 1.5% and as little as .01% depending on the level of deposits you make. However for the past 5 years, inflation has hovered between 0.76% and 2.07%. and inflation forecast for the next 5 years is between 2% and 2.5%.
Losing “purchasing power” in a savings account
Assume you have a savings account with $1,000 earning the average interest rate banks offer, .06% annually. This means your $1,000 will earn you a mere 60 cents at the end of one year for a total of $1,000.60.
Now if the inflation rate is around 2%, this would mean that many goods and services you could purchase at one point with $1,000 will now be 2% more expensive. In short those goods or services would now cost you $1,020.
And while the money in your savings account grew from $1,000 to $1,000.60, you’d now need $1,020 to purchase the same amount of goods and services.
Is a savings account a bad idea?
Nope. A savings account is a great tool to help you keep money safe and ready for soon to come expenditures (next year vacations, christmas gifts, emergency funds, etc).
However, when it comes to long-term financial goals, like retirement or saving for college, an investing account may be the way to go.
What is “investing"?
When you invest you are exchanging your savings in the form of cash for some other type of ownership that has the opportunity to bring you some monetary benefit in the future. The goal of investing is putting your money to work by exchanging the excess cash you have for some other type of ownership. For example when you exchange cash for stocks, bonds or real estate, you are investing.
What is an investing account?
An investing account is a type of financial account that allows you to purchase stocks, Exchange Traded Funds (ETFs) and other investments offered through the stock market. Your investing account in essence is the means for you to be able to buy and sell shares of companies that are part of the stock market.
When you invest in stocks through an investing account, you’re exchanging cash for pieces of companies (stocks) whose main goal is to generate as much value to investors as possible. As a shareholder of a company (owner of stocks) you are also the owner of the profits and revenue the company generates proportionally to how many shares you own. You are also affected by the losses of the company proportionally to how much stocks or fractions of ownership of the company you own.
How does “investing in the stock market” work?
The stock market in its most basic form, is where people who own pieces of companies meet people interested in buying pieces of those businesses. The people interested in buying pieces of a business or stocks are called “investors.”
You can start to understand how the stock market works by comparing it to one of the most common markets there are, a food or farmer’s market.
At a farmer’s market, you’ll find customers interested in buying food, fruits and vegetables. You’ll also find farmers looking to sell the product it took many months for them to raise, plant or grow. The stock market is no different.
Founders and other early investors in a company usually go to the stock market to sell pieces of the company they help create in exchange for cash.
And just like buyers at a farmer’s market are looking to purchase tomatoes or onions for their next delicious dish, investors go to the stock market to find suitable investments to put their money to work.
So when you buy stocks like Apple, Microsoft or Amazon, among thousands of other stocks available, you are buying pieces of that company from a previous owner (aka shareholder). And just like people at a farmer’s market buy food for eating, investors buy stocks or other investments expecting they can obtain a positive monetary benefit from the company they purchase.
One key feature of the stock market in comparison to a farmer’s market, is that a buyer of a stock can also sell the stock they purchased in that market at a later date, hopefully at a higher price. This is all done through an investing account like the one offered through Stash.
And just like the price of food can vary in a farmer's market depending on the demand of that product (think of the price of avocados when demand is high), the price of stocks can also increase or decrease depending on how many people want to buy or sell a particular stock.
One of the main drawbacks of investing is the fact that some companies may not succeed in creating profit or revenue. This could cause your investment to lose value. When you own a share or stock, you become the owner of a small fraction of a company.
A company that could have great sales and growth but also a company that could fail to grow, generate losses or even go bankrupt.
Building a portfolio on your own
A portfolio is a fancy word for saying “a group of all of your investments and monies”. Your portfolio may include stocks and cash, even other investments like bonds, exchange-traded funds (ETFs) or real estate. You can think of a portfolio as a pie made of investments representing different types of ownership.
The previous image shows an example of five different portfolios. However there are millions of different forms a portfolio can be built. This is when the concept of portfolio management comes in handy. Portfolio management is the process of creating a balanced and suitable portfolio to match your future financial goals.
In order to create a balanced and suitable portfolio, you need to have a diversification strategy. A diversification strategy means having some your some of your money allocated to investments with different characteristics. For example, cash is not highly affected by changes in the price of stocks, but it is affected by inflation.
Stocks might not be affected by inflation, but stocks can be affected by overall market prices. Building a balanced and suitable portfolio strategy depends on the length of time you want to invest, and your future financial goals.
Diversification and your portfolio
Diversification is an investing strategy. In short, it means not putting all your eggs in one basket. It helps people looking to put money for the future distribute risk among different investments so if one performs poorly, losses aren’t as extreme as they would be if you only had one investment.
An example of a poorly diversified portfolio is one where your money is invested in a single stock, or even all in the form of cash in a savings account. For instance, if all your money is invested in just one oil company, you could lose big if the company goes bankrupt, or if the price of oil goes down. If you have all your savings in cash, and inflation is higher than the interest rate you earn in that account, then you also risk your money having less purchasing power in the future.
In contrast, a well-diversified portfolio is one where your cash is allocated in different investments and asset classes. An example of more diversified portfolio may include some money invested in oil stocks, some in healthcare stocks, some in bank stocks, some in real estate, some in bonds and some money kept in a savings account.
Diversification does not guarantee you won't lose money, it simply helps you spread the risk. So if one investment loses value, others are probably not impacted to a similar magnitude.
What is the point of a portfolio?
A portfolio is usually built to match personal financial goals. Your goals and how much risk you want to take on to achieve them may depend on your age, along with your ability and willingness to take risk on the investments you make.
The previous infographic shows a very general picture of some of the portfolio mixes suggested by economist Burton Malkiel. Malkiel, a professor of economics at Princeton University, is famous for arguing that most investors can’t beat the market over the long run and that general investors are better of putting their money on diversified passive investments like index funds or Exchange Traded Funds (ETFs). ETFs allow you to purchase many different stocks without the need to buy each single stock to diversify your portfolio.
Based on Malkiel recommended portfolios, you can see how both a savings account and an investing account could be useful to create a balanced and suitable portfolio depending on your financial goals and age.
How to build your portfolio with Stash
If you feel comfortable now knowing what the difference is between having an investing account and a savings account, and how they both can help you towards getting a balanced and suitable portfolio, Stash can help you set-up your investment account with as little as $5.