Savings vs. Investing - Beating Inflation
- The major difference between saving and investing is the risk versus the reward.
- Inflation is when the buying power of an individual dollar decreases while the average price of goods and services increases.
- Having a solid investment strategy in place will help you minimize the impact of inflation on your savings, investments, and any other long-term financial goals.
Saving and investing are both important when you want to secure your financial future. However, it is most helpful when you can make an educated and strategic decision on when it is best to invest or when it is best to save. Most importantly, you will need to know how inflation can affect your efforts in both saving and investing.
What are the key differences between saving and investing?
The major difference between saving and investing is the risk versus the reward. Saving allows you to earn a lower return with virtually no risk. On the other hand, investing will enable you to make a higher return but with some level of risk.
You set aside money when saving, which could be on a recurring basis or when you have extra income. Those funds are saved for future purchases or emergencies. On the other hand, investing includes buying assets such as bonds, stocks, mutual funds, and real estate. In return for making those investments, you expect them to make money for you by providing you with a return on investment (ROI).
Saving vs. Investing – when and how?
Saving has less risk because money in your bank account will not typically reduce unless you make a withdrawal. However, interest rates on savings accounts are usually lower than the price of inflation, which results in the loss of purchasing power.
That said, you might be tempted to invest to receive higher returns and beat inflation. However, it's important to note that all investments involve some degree of risk. The value of your investment will not always increase, and you can potentially lose funds. In general, as investment risks rise, you will seek higher returns to compensate for taking such risks.
So, how do you know when you should stick to saving or risk more with investments for bigger returns? First, take time to assess your current financial picture because you want to make sure that you have an adequate amount of savings to protect you in the event of an emergency. You then want to write down your future financial goals, know your risk tolerance (what you can afford to lose), and understand how inflation affects your savings and investments.
What is inflation?
Inflation is when the average price of goods and services increases. More specifically, the buying power of an individual dollar goes down as the price of everything goes up. For example, the cost of buying a bicycle today is $100, and the current inflation rate is 2%. Next year, the same bike may cost you $102, assuming the price also increases with the rate of inflation.
How does inflation affect your savings and investments?
For your savings, when inflation is higher than the interest rate paid on your savings account, it means you're losing the value of your money over time. For example, one thousand dollars ($1,000) in the year 2000 does not equate to the value of $1,000 in 2022. A more specific example is that people could purchase four small bags of chips twenty years ago for one dollar ($1), paying 25 cents each. Fast forward to today, one bag of chips costs 50 cents or more.
Inflation can also chip away your returns. This is because your investments must also keep up with the rate of inflation to increase real purchasing power. For example, if the inflation rate is 3% and your investment return is 3%, your actual performance is 0% when adjusted for inflation.
Inflation is particularly harmful if you have fixed-income investments such as bonds. This is because payments are fixed, and if inflation rises, the purchasing power declines.
How do you account for inflation?
While you cannot typically avoid the market forces of inflation altogether, you can plan for it by putting a solid investment strategy in place. A strong strategy will help you minimize the impact of inflation on your savings and long-term financial goals.