Thursday, January 31, 2013

The Difference Between Saving and Investing

Even though the words "saving" and "investing" are often used interchangeably, there are differences between the two.
Saving provides funds for emergencies and for making specific purchases in the relatively near future (usually three years or less). Safety of the principal and liquidity of the funds (ease of converting to cash) are important aspects of savings dollars. Because of these characteristics, savings dollars generally yield a low rate of return and do not maintain purchasing power.
Investing, on the other hand, focuses on increasing net worth and achieving long-term financial goals. Investing involves risk (of loss of principal) and is to be considered only after you have adequate savings.

Savings vs. Investment Dollars

Savings $$Investing $$
  • Safe
  • Easily accessible
  • Low return
  • Used for short-term goals
  • Involve Risk
  • Volatile in short time periods
  • Offer potential appreciation
  • For mid- & long-term goals

Investment Return

Total return is the profit (or loss) on an investment. It is a combination of current income (cash received from interest, dividends, etc.) and capital gains or losses (the change in value of the investment between the time you bought and sold it). The published rate of return for a selected investment is usually expressed as a percentage of the current price on an annual basis. However, the real rate of return is the rate of return earned after inflation, which is further reduced by income taxes and transaction costs.

Illustration of "Total Return" and "Rate of Return"

Current Income+ Capital Gain (or Loss)= Total Return
Ex:$2+ $1= $3
Annual Return÷ Current Price of Security= Rate of Return
Ex:$3÷ $24 (per share)= .125 or 12.5%


Historically, stocks have had the highest average annual investment return of all types of investments, especially over long time periods of 10 years or more. The average annual rates of return for major investment asset classes from 1926-2011, according to the Chicago investment research firm, Ibbotson Associates, were: 9.8% large company stocks, 11.9% small company stocks, 5.7% government bonds, 3.6% Treasury Bills, and 3.0% inflation