Growing what you earn

If you’ve only recently started on your journey to financial independence, you may think saving and investing are the same. They seem to be used in the same context much of the time. Both are about putting money aside for the future, but the differences between them are important to help us make the right choices about what to do with our money.

Savings is about protecting your money while investing is all about growing your money. You definitely need both. Exactly how much goes into which depends on your wants and needs. The first point is to make the choice to spend less than you earn, leaving you some money left over every month to both save and invest. Don’t wait for month end to save or invest, take that money out the day your salary arrives so you’re not even tempted to spend it on other wants.

Savings is then the money you want to keep safe for use in the short-term. This could be budling up an emergency fund, a deposit on a house, a holiday or anything else. The key with savings is that it is money that you expect to need within the next three or so years. While it is boring and has very little growth, often struggling to keep up with inflation, it will be there when an emergency strikes or you decide to take that holiday.

Inflation is a concern for your savings. This money will be in a short-term savings account and it will likely get a very modest rate of interest. It might actually be very boring as it slowly ticks higher. The money you have saved today will still be the money you have tomorrow, with a little bit of interest added, and that is the point of saving – safety of that money so your short-term money goals are achieved.

The problem is inflation. Every year your money in the bank buys you a little less, as your interest rate is almost certainly lower than the rate of inflation. This has two implications. Firstly keep an eye on your needs and make sure your savings are growing to meet them. You may need to top up every so often to combat inflation.

Inflation is why we don’t use savings for long-term financial goals like retirement. We’d struggle to keep up with inflation and we would not have created any meaningful wealth even if we saved for decades.

Investing is the antidote to inflation. We need to work out how much we need saved and stick to that number, not just throw everything into savings. Once your sort-term savings are sorted and the slightly longer term savings (such as that deposit for a house one day) is on track, you can then turn to investing.

Investing is for those proper long-term goals such as retirement in a couple of decades. Because you have time on your side, you can afford to take some risk. For that we look to the stock market and other alternative assets. Here we get better returns than when we save because we’re taking on the extra risk. But time smooths out risk.

You can imagine this process as a ratio of assets to risk to time.

You have cash, but when you add time to cash, you introduce inflation as a risk factor. To combat the risk of inflation, you invest, but each investment comes with a different type of risk. To combat the risk introduced by an asset, you add time. See how it forms a little ecosystem?

A simple example here would be starting your own business. Firstly, you wouldn’t take everything you have and put it into the new business venture, you’d only take some savings to start the business. While you fully expect the business to do well, it may not. There will be periods when things are tough and there may not be any profits. You don’t panic during the tough times. As a business owner you’ve seen them before and you make some changes to survive and wait for the return of the better days. There is also the reality that the business you started fails and you end up with nothing: no business and no profits.

Investing carries the same risks and these risk are very different to the risks of your savings in a boring bank account. But we can manage these investment risks.

The first way to manage this investment risk is to have time on our side. A long-term view means we can ride out the tough times waiting for better times and profits to return. We also manage the risk by having different investments. In the above example of your own business, if you’d put everything you had into the business and it failed, you’d have nothing left.

But you’re smarter than that! You put some money into the new business and the rest went into other investment options. If one does fail, the rest can continue growing adding to your wealth and securing your future.

It is also why we don’t put our short-term savings needs into an investment. Not only might it fail, but if you need your savings and investments are doing badly you won’t have enough for your short-term savings goals.