If there’s one financial rule we’re all familiar with, it’s the importance of saving. From the first time we add a penny to a piggy bank, we learn that it’s a good idea to stash some cash for a rainy day.
But as we venture into the world of adult finances, our cash-stashing options get a lot more diverse than ol’ Mr. Piggy. When you’ve got excess cash on hand, you can choose to stick it in the bank or invest it in a multitude of assets.
So what exactly is the difference? Is the market’s risk worth the gamble? And when is it a better idea to keep your assets liquid — that is, in cash — versus taking advantage of the power of compound interest?
Saving vs. investing: an overview
For the purposes of this article, here’s how we define these two important terms.
Saving is when you deposit your excess cash in a bank account, perhaps in an interest-earning savings account or certificate of deposit (CD). Saving your money keeps it more accessible (with the exception of CDs), and because it’s not vulnerable to the stock market’s whims, you don’t really have to worry about losing your hard-earned cash. However, even the highest-yield savings accounts can’t match the earning potential of the stock market, so you won’t make much in the way of capital gains. Your money will just sit there instead of going to work for you.
Investing is when you use your funds to buy company shares and other assets, giving it the chance to earn substantial capital gains over time. There are a variety of investment accounts to choose from, many of which are geared toward specific financial goals, such as retirement (401(k)s, IRAs) or funding a college education (529 plans).
Although investing gives you higher earning potential than saving does, it does come at a risk: Stock market crashes, recessions and failing companies are all financial realities. However, historical performance suggests (and many financial professionals agree) that long-term investing is more likely to grow your nest egg than squander it as long as you don’t rip all your money out of the market at the first sign of trouble.
3 times saving your money might be smart
Although investing is the best way to set yourself up for a comfortable retirement (and achieve other large, long-term financial goals, such as buying a house), there are some scenarios in which saving your money may be more prudent.
1. To cover emergency expenses
No matter where you are in your financial journey, life happens — and you need to have a cushion of cash saved up to pay for those unexpected events. So if you don’t already have an emergency fund, you should prioritize saving up that money before you turn toward investing. Even though you’d stand to earn higher gains on the market, you need your emergency money readily available just in case.
How much of an emergency fund is enough? Many financial professionals recommend saving three to six months’ worth of living expenses, including regular expenses like rent and electricity as well as necessities with more budgetary wiggle room like food. This money should be kept in an account with few or no access restrictions or timeline requirements so you can access it quickly when you need it.
2. For shorter-term financial goals
If you’re saving for a sizable financial goal you want to execute in the next few years, it might be a better idea to save rather than invest. For instance, if you invest money you plan to use next year and the market takes a tumble, your short timeline means you may not be able to leave the money in the market long enough for it to recover your losses. Plus, if you keep your stock market holdings for just a short while, you may pay higher taxes on your capital gains.
A key to figuring out how much money you’ll need and when is to devise a solid financial plan. Once you have a better idea of your specific financial goals and when you plan to reach them, you can decide how much money to set aside for the short term versus how much you can afford to invest.
3. To pay off high-interest debt
Paying interest is a serious financial anchor — especially the high-interest commercial credit lines on which many Americans carry a revolving balance. Every penny you pay toward interest is one you can’t put toward other financial goals. So if you’ve got a significant amount of high-interest debt, it might be a good idea to chip away at it with readily accessible savings before you get serious about investing.
2 times investing could be best
While saving can help safeguard your finances in the short term, longer-term goals usually are best served by investing. Given enough time, compound interest can turn even modest savings into an impressive sum.
1. For retirement
Most of us hope to someday punch the clock for the very last time, living out our golden years without having to worry about working.
But taking an income without actually earning any money requires a big chunk of stashed change. Even if you plan to live on $40,000 a year in retirement, you’ll probably need about a million dollars saved up, according to Business Insider. That’s a hard figure to reach by sticking your money under the proverbial mattress.
Investing is a common-sense way to reach your retirement goals — especially if you work at a company that offers a 401(k) (and especially especially if your employer offers a match).
“You always want to put something away inside of your 401(k),” said Malik S. Lee, certified financial planner and founder of Felton & Peel Wealth Management. And that employer match percentage amount is well worth meeting; it’s basically free money.
2. To buy a house (or fund another major purchase)
If your financial plan includes big purchases that are more than five years down the line, investing can help you get the leverage you need to make them happen. Just be sure you aren’t utilizing an investment vehicle with specific and strict timeline regulations like those geared toward retirement; you generally can’t withdraw money from those accounts before you reach retirement age without incurring a penalty.
Both saving and investing are important financial tactics to get you set up for your financial future (and put your mind at ease in the present). And it isn’t a zero-sum game; ideally, you’ll be able to do both. That way, you’ll be able to take advantage of the power of compound interest while ensuring you have some liquid assets available for your short-term needs — which is what we call a win-win situation.