Many new investors don’t understand that saving money and investing money are entirely different things. They have different purposes, and play different roles, in your financial strategy and your balance sheet. Making sure you are clear on this before you begin your journey to building wealth and finding financial independence is vital because it can save you from a lot of heartache and stress.
Cash deserves respect. Its goal is not always to generate a return for you.
Perhaps the best place to start would be to spell out the differences between saving and investing for you, defining both concepts.
The Definition of Saving Money
Saving money is the process of putting cold, hard cash aside and parking it in extremely safe, and liquid securities of accounts, meaning they can be sold or accessed in a very short amount of time. This can include checking accounts and savings accounts. This can include Treasury bills and money market accounts, but not always money market funds as you need to look at the holdings and structure closely.
Above all, cash reserves must be there when you reach for them; available to grab, take hold of, and deploy immediately with minimal delay no matter what is happening around you. Many famous wealthy investors, as well as older investors who lived through the Great Depression, actually advocate keeping a lot of cash hidden on hand somewhere that only you know about even if it involves a major loss.
Only after capital preservation is accounted for do you worry about secondary considerations for money you have parked in savings. Namely, keeping pace with inflation.
The Definition of Investing Money
Investing money is the process of using your money, or capital, to buy an asset that you think has a good probability of generating a safe and acceptable rate of return over time, making you wealthier even if it means suffering volatility, perhaps even for years. True investments are backed by some sort of margin of safety, often in the form of assets or owner earnings. The best investments tend to be productive assets such as stocks, bonds, and real estate.
How Much Should I Save Versus How Much Should I Invest?
Saving money should almost always come before investing money. Think of it as the foundation upon which your financial house is built. The reason is simple. Unless you inherit a large amount of wealth, it is your savings that will provide you with the capital to feed your investments. If times get tough and you require cash, you’ll likely be selling out your investments at the worst possible time. That is not a recipe for getting rich.
There are two primary types of savings programs you should include in your life. They are:
- As a general rule, your savings should be sufficient to cover all of your personal expenses, including your mortgage, loan payments, insurance costs, utility bills, food, and clothing expenses for at least six months. That way, if you lose your job, you’ll be able to have sufficient time to adjust your life without the extreme pressure that comes from living paycheck to paycheck.
- Any specific purpose in your life that will require a large amount of cash in five years or less should be savings-driven, not investment-driven. The stock market in the short-run can be extremely volatile, losing more than 50% of its value in a single year. Purchasing a home is a great example.
Only after that these things are in place, and you have health insurance, should you begin investing.