Money Matters: Savings vs. investments: Finding the right balance for your financial goals
Fortunately, you have found yourself in a position to tuck some money away. But do you put it into your savings account in the case of rainy financial weather, or do you invest it with the hopes that it will grow?
Both strategies play crucial roles in building wealth and securing one’s financial goals. Finding the right balance between savings and investments is essential to achieving your long-term financial goals.
This article will explore the differences between savings and investments, their respective benefits and risks and how to strike the perfect balance to align with your individual financial objectives.
Understanding savings is simple: Savings is whatever money is left over after accounting for essential and discretionary expenses. However, there are several locations where your savings can be stored.
First off, you could take the saying “cash under the mattress” literally and store your savings in the form of cash, although keeping more than a very small emergency fund is not recommended by experts. Traditional savings accounts offered by banks are probably the most widely used today and are considered safe and easily accessible. Savings accounts often yield modest interest rates and serve as a liquid emergency fund. Financial experts recommend having three to six months’ worth of living expenses in savings to cover unexpected events like job loss or medical emergencies.
Regardless of where you decide to store your hard-earned cash, saving is an essential foundation for financial security and provides a safety net during times of uncertainty.
Benefits and limitations of savings
The primary benefit of savings lies in its low-risk nature. Federal deposit insurance, up to a certain limit, protects savings accounts in most countries, ensuring that the principal amount remains secure even if the bank faces financial challenges.
However, the conservative nature of savings accounts also means that their growth potential is limited. With interest rates often failing to keep pace with inflation, savings may lose value over time in real terms.
Investing involves allocating funds into various assets with the expectation of generating returns or capital appreciation over time. Types of assets can include stocks, bonds, real estate, mutual funds and more. Compared with savings, investments carry a higher degree of risk but offer the potential for substantial growth. The key to successful investing lies in understanding your own risk tolerance, diversifying your portfolio and adopting a long-term perspective.
Benefits and risks of investments
Investing offers the potential for higher returns than traditional savings accounts. Historically, the stock market has outperformed inflation, providing investors with a way to grow their wealth. The average stock market return over the last 10 years has been 12.4%, adjusted for inflation. Conversely, the average savings account has an interest rate of 0.42% APY, with the highest-yielding reaching up toward 5% APY.
However, investments come with inherent risks, as markets can be volatile and subject to fluctuations. It’s essential to assess one’s risk tolerance and time horizon before making investment decisions.
Assessing financial goals, time horizon and risk tolerance
To strike the right balance between savings and investments, individuals must first assess their financial goals. Short-term goals, such as purchasing a car or funding a vacation, are best served through savings or low-risk investments. On the other hand, long-term goals, such as retirement or funding a child’s education, may require a more aggressive investment approach to outpace inflation and accumulate substantial wealth over time.
It may seem counterintuitive to choose lower-risk options in the short term and high-risk options in the long term. However, the reasoning behind these strategies has to do with the ability to bounce back within your chosen time frame. If you invest in high-risk assets in the short term, a single economic downturn could wipe out the entirety of your investments. Conversely, longer time horizons can facilitate higher-risk investments since there will be plenty of time for your investment portfolio to recover in the case of economic turbulence.
Individual personality, risk tolerance and age also impact the optimal balance between savings and investments. Younger individuals with longer investment horizons may be more keen to take on higher-risk investment strategies, as they have time to weather market fluctuations and potentially recover from any losses. Older individuals nearing retirement may opt for a more conservative approach to safeguard their accumulated savings and reduce exposure to market volatility.
With so many investment and saving strategies to consider, delineating specific financial objectives is crucial and will help you determine where to best allocate your funds.
Diversification as a risk mitigation strategy
If you decide to put any significant amount of your money into investments, it is paramount to develop a diversification strategy. Diversification is a fundamental principle of investing that helps manage risk, regardless of your financial goals, time horizon, age, or risk tolerance. Spreading investments across different asset classes, industries and geographic regions can mitigate the impact of a downturn in any single investment. Therefore, diversification may allow an individual close to retirement to keep most of their money in savings or low-risk investments while taking a more aggressive approach with the remaining funds.
The right diversification strategy depends on the same factors as determining the balance between savings and investments — financial goals, time horizon, age and risk tolerance. For example, if you plan to retire in 10 to 20 years and have already built a substantial nest egg, you may want to adopt a conservative portfolio. A sample low-risk portfolio may include something like 20% stocks, 30% short-term investments and 50% bonds. It is crucial to diversify the investment portfolio according to individual financial goals and risk tolerance, as this strategy can contribute to long-term stability.
Balancing savings and investments
A balanced approach to financial planning involves maintaining an emergency savings fund while simultaneously investing for growth. For short-term goals, such as building an emergency fund or saving for a down payment on a house, savings accounts or short-term certificates of deposit (CDs) are preferable. For long-term goals, retirement accounts like IRAs and 401(k)s offer tax advantages and a chance to invest in a diversified portfolio of stocks and bonds.
Finding the right balance between savings and investments is a critical aspect of achieving financial success. While savings offer security and liquidity, investments provide the potential for higher returns and wealth growth. Striking the perfect balance depends on an individual’s financial goals, time horizon, risk tolerance and diversification strategy. By carefully considering these factors — and seeking professional advice when needed — individuals can create a comprehensive financial plan that aligns with their objectives and secures their financial future.
Jacob Bingham is a project manager at Stage Marketing, a full-service content marketing agency based in Pleasant Grove.