When should you save, and when should you invest? The answer depends on what you have planned for the future - and what you want to do with your money.
First, let’s look at the most important differences between saving and investing. Then, we’ll
help you figure out which is right for you.
In this blog we’ll cover:
How a savings account works
How an investment account works
Pros and Cons of savings accounts and investing accounts
Typical ways to start investing
Overall takeaway
The differences between saving and investing
Broadly speaking, when you put your money into an investment account instead of a savings account, you can expect to earn a greater return in the long run, but with some risk. Your return depends on how your investments perform. The value of investments can go up or down.
When you put money into a savings account, it collects interest at a steady, seldom changing rate that’s set by your financial institution. You can make a predictable return, but you have the potential to earn more through investing.
How a savings account works
The money you put in your savings account earns interest.
If you want to maximize interest on the money in your savings account, you should opt for a high interest savings account –you may get 1.5% or even 2.45% annual returns on your savings. Be aware that some financial institutions may have promotions where the interest rate offered is higher in the first few months, but then drops considerably. Others may have restrictions on minimum balances and how often you can make withdrawals.
How an investment account works
When you put your money into an investment account, you’re able to invest the money in a variety of assets, most commonly stocks, mutual funds and ETFs.
We believe it is beneficial to use an investment account over a savings account if you’re planning to keep the money invested for more than one year. All investments have a certain level of risk. If you’re new to investing, it can be intimidating, but keep in mind that risk and reward go hand in hand. While the stock market sometimes experiences a dip, historically it has always gone up in the long-run and as an investor, you can benefit from these gains.
The type of investments you choose will depend on your goals for the future, risk tolerance, and how much money you have to work with. If you have a long time horizon before you plan to use the money, (say, 10-20 years) you can choose a portfolio with a higher level of risk. These portfolios are typically comprised of stocks and other assets. You have the chance to earn a high return, but there’s also chance you could lose money if you withdraw your money while the stock market down.
If you plan to use the funds in less than five years, you would likely want to choose a lower risk portfolio. These portfolios typically have a high composition of assets with relatively low volatility such as bonds, mortgages, and other income focused investments. You can expect a lower return, but you probably won’t lose a lot of money.
We believe it is beneficial to use an investment account over a savings account if you’re planning to keep the money invested for more than one year.
Pros of saving
There are plenty of benefits to saving rather than investing. First, the dollar amount you save in a savings account won’t decrease over time as long as you don’t make withdrawals. This is important because some goals need to happen regardless of whether investment prices are up or down.
Saving rather than investing also allows you to reach your goal on time as long as you save the proper amount each month. Take the total you need to save and divide it by the number of months until you need to reach your goal to find the amount you need to save each month.
Cons of savings
Saving does have downsides though. Due to inflation, the money you save will decrease in value each year. If you earn interest, that interest may partially offset the negative effect of inflation. Unfortunately, interest rates rarely keep up with the rate of inflation.
Saving also means you’ll have to set aside more money each month than you would if you received higher returns investing. If you’re only earning one percent interest in a savings account but could earn an eight percent return investing, you’ll have to make up for that seven percent difference by putting more money in your savings account to reach your goal at the same time.
Pros of investing
Investing can be beneficial, too. Investing gives your money the potential to grow faster than it could in a savings account.
If you have a long time until you need to meet your goal, your returns will compound. Basically, this means in addition to a higher rate of return on investments, your investment earnings will also earn money over time.
The benefit of higher compounding returns is you won’t have to invest as much each month as you would need to save each month to reach your goal.
Cons of investing
Investing isn’t always a good thing, though. Investment prices could go down right before you need the money which could leave you in a financial bind.
If this happens, you will have to either settle for an option that doesn’t cost as much, delay your goal until you can save more money or delay your goal until your investments increase in value.
When and how to save and when to invest:
Knowing when to save or invest can be difficult. Every person’s situation is truly unique. You should base your decision on your particular situation. If you’re not sure what to do, you should consult a fiduciary financial advisor that can help you decide. However, there is a general framework that ends up working for many people:
Step 1: Build your retirement account
First, start a RRSP or TFSA or jump on your companies DCPP or DPSP. If your workplace matches the money you put into your retirement account, it’s essentially “free” money you shouldn’t pass up.
Step 2: Build your emergency fund
Next, build a small $500 to $1,500 emergency fund in a savings account. A small emergency fund is essential to help you stay out of debt for good.
Rather than putting small emergencies on your credit card that could dig you deeper into debt, you can rely on your emergency fund to cover small emergencies.
Step 3: Pay off debt
After you build your small emergency fund, pay off high interest rate debt. What you define as high interest rate is up to you, but definitely includes debt with interest rates 10 percent and higher. Ex. Credit Cards, Credit Lines, Private Loans.
Step 4: Max out retirement accounts
Next, invest and max out your TFSA and or RRSP. Plan with your advisor whether and RRSP or TFSA is better at the time, but either way you should invest in a tax advantaged account. In 2020, you can contribute up to $6,000 per year in your TFSA and up to $27,230 or 18% of your income in a RRSP, which ever is less.
After that, you can get more speculative. Ex. Real estate, private equity, health care etc.
Takeaway
If you’re putting aside money for less than a year, or you need to have quick, easy access to it, we typically suggest putting your money in a savings account, or High interest Savings Account (HISA).
But if you want your money to make you more money, consider opening an investing account.
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