What is the Difference Between Saving and Investing?

by Joe Plemon on August 13, 2014

Most of us innately know that saving and investing are not the same, but do we understand the difference? Because clarity in this distinction can greatly impact one’s financial well being, realizing these difference is vital. The key is in two words: risk and liquidity.

Savings are low risk funds that must be liquid (available) when you need them. The purpose of saving money is so you can have it for a specific purpose within a short time frame.

Investments, on the other hand, are for wealth building, and will not be needed for many years. Yes, investments do involve greater risk, but, investments also yield much greater returns when left alone long enough to ride out the turbulence of the stock market.

Examples of savings

Emergency Fund

When an emergency happens, the money is needed immediately. The emergency fund, therefore, should be in a very boring account, such as a Savings Account or Money Market Account. One could also consider an online high interest account, as long as the funds are easily accessible. Its purpose is not to make a bunch of money; it is there for emergencies.

Car Fund

You DO save up and pay cash for your cars, don’t you? This money should be saved, not invested. Why? Because you don’t want to take the risk of a market plunge just when you are ready to buy.

Anything else you will need to pay cash for

What are you saving for (notice the word “saving”)? A home improvement (or repair), a riding lawn mower or a new computer are all examples of saving: you will need a set amount on a set date.

College Funding (sort of)

Should college funding be an investment or saving? It depends on how soon Junior is going to be entering college. If college is 18 years away, the money should be invested (make sure you use an ESA or 529 plan to get all of the tax breaks). But what if college starts four years from now? You don’t want the risk of your investments tanking just when that first tuition payment comes due. The choice is yours, but I think you should be moving those funds to a less risky vehicle (maybe even a savings account) as the time of need approaches.

Examples of investments

Retirement

Yes, retirement is the big one and retirement funds should definitely be considered investments.  Such funds should be rebalanced annually or even bi-annually, but you basically leave them alone and don’t worry about checking the stock returns by month.  However, like college funding, the retirement nest egg should be made safer as the time of need draws closer.

Starting a business

If you have a long range plan to start up a business (say 10 to 20 years from now), you should be investing to achieve the nest egg needed.

Breaking it down

The difference between investing and savings is really quite simple. If you are going to need the money in the near future, save it. If you aren’t going to touch the money for a longer time frame, invest it. The trick is defining this time frame. Financial guru Dave Ramsey uses five years as his criteria. His rationale is that the stock market has historically made money in 93% of the five year rolling time frames and in 100% of the rolling ten year periods. Most of us are aware that the recent recession changed those percentages, and I heard Dave Ramsey recently say that the stock market has made money in 100% of all rolling fifteen (no longer ten) year periods. However, as far as I know, Dave still uses the five year criteria to distinguish saving from investing.

What do I think about the five year guideline?

I am OK with it. If I know I will need to tap the money in five years or less, I consider it savings. Our emergency fund and car fund are both in Money Market Savings Accounts. On the other hand, if I am not planning to touch the money for longer than five years, I invest it. Our traditional and Roth IRA’s are examples of our investments.

I also have a sort of hybrid investment fund. I am currently involved in flipping a house. This is clearly an investment, with money tied up in the house. However, when we sell the house, I plan to keep this money quite liquid and available (like a savings account) so I can be poised to buy another flip house. I say hybrid, because I would at that time have an investment that I am treating like savings.

How about you? Do you have a clear guideline to distinguish saving from investing? What is that guideline?

Creative Commons License photo credit: Ken Wilcox.

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{ 26 comments… read them below or add one }

Money Reasons June 21, 2010 at 5:43 am

Excellent job distinguishing between the two!

Long term money should be invested according to one’s risk tolerance, whereas saving (in a bank), is definitely intended for short term usage.

Nice job all the way around!

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Khaleef @ KNS Financial June 21, 2010 at 12:58 pm

Good article! It is very important for us to be clear about the different functions of these accounts and to be sure that our expectations match.

I would agree with the 5-year mark. I have always told people that.

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joeplemon June 21, 2010 at 2:21 pm

@Money Reasons,
Thanks for the encouraging words. Good to know that I am making some sense. :)

@Khaleef,
Just curious: how did you come up with the five year mark? On your own? Through another financial article? From Dave Ramsey?

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Ace June 21, 2010 at 3:25 pm

Great jot in making the clear distinction between the two. Savings often don’t get the great reputation that they should. I think people are often allured by the possibility of making 10% in the stock market and neglect their poor savings accounts.

Your description of the emergency fund is excellent, “a very boring account, such as a Savings Account or Money Market Account.” It always makes me cringe when I hear about people investing a whole bunch of money in the stock market without having a sizable emergency fund first.

Great post!

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joeplemon June 21, 2010 at 4:51 pm

Ace,
Thanks for the thumbs up. This stuff isn’t all that difficult, but, like you say, too many people ignore savings because they have such grandiose plans. My guess is that the vast majority of these are men. Women are OK with savings because they appreciate the security. Men, on the other hand, prefer investing because money, to them, is a competition.

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Carol@inthetrenches June 21, 2010 at 5:24 pm

Glad you made this distinction for your readers. Everytime I hear the word savings and stock market in the same sentence I cringe. I have two very close friends who are very conservative with their finances that lost their total “retirement savings” in the stock market. Since they were over 60 this was a devastating blow. I believe this terminology started getting melded together in the 80s when there was a big push for non taxable 401k plans.
I wrote a post in March that focused on those who have difficulty in starting a savings plan that may be useful to your readers if you care to share it. http://inthetrenches2009.blogspot.com/2010/03/living-under-your-means-part-3-other.html

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joeplemon June 21, 2010 at 8:00 pm

Carol,
I agree! “Retirement savings” sounds like an oxymoron to me, sort of like “good debt” (but that is another subject).

Too bad about your friends, but allow me to ask: if they were so conservative, how did they manage to lose ALL of their retirement investments in the stock market? Just curious.

Thanks for the link to your post. Readers: jump over to Carol’s site to read some great common sense tips on saving.

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Carol@inthetrenches June 21, 2010 at 10:08 pm

Regarding the loss of retirement income. They were not detailed with the actual how but one allowed a well known investment company to manage their portfolio and it was invested mostly in real estate bundled funds. The other did their own investment research and didn’t fare any better. One family was able to retire anyway with less income and the second has had to add another few years to her working career despite already reaching retirement age and an unhealthy older spouse. Both are resilient and will buckle down and make it but have had to make many changes to their plans.

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Roshawn @ Watson Inc June 22, 2010 at 6:49 am

Good distinction. People often confuse the two when they do have two entirely different purposes. Following the five year rule has truly benefited me in the past. Thanks for sharing.

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joeplemon June 22, 2010 at 2:38 pm

@Carol,
Thanks for follow up info. I am always interested in learning from how financially conservative people can have devastating results. This has had to have been very tough on your friends, but I am glad that they are resilient.

@Roshawn,
The five year rule seems pretty common. How did you happen to choose five years as the distinction between saving and investing?

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Darren June 22, 2010 at 2:49 pm

In my opinion, five years seems like too short of a timeframe to be invested in the stock market. As you noted, with the recent downturn, it doesn’t seem like a long enough period to ride out the bumps. Even ten years doesn’t feel any better for averaging out the fluctuations.

Fifteen years seems like a good starting point to me, and 20 plus years is even better. That’s why I feel it’s important to start as early as possible and think long-term while still living in the present.

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joeplemon June 22, 2010 at 3:12 pm

Darren,
I admit that the recent downturn does make five years seem awfully risky. But here is the question: With a 15 year time frame, if you want to start saving for Junior’s college education when he is 3, you would avoid any investments (all savings) during that time until he is 18. Would that be all right? Maybe, or maybe not depending on risk tolerance. Or, if you are planning to retire at age 65, you would be moving your funds toward savings at age 50. Maybe that would be OK. It depends, again, on risk tolerance.

I do believe we live in a different financial climate now than we did just three years ago, and I hope we can learn from it. I can tell that you have learned much by these words, “I feel it’s important to start as early as possible and think long-term while still living in the present.” Too many people get caught up in playing catch up and take too many risks.

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Khaleef @ KNS Financial June 22, 2010 at 3:57 pm

@ Joe, I honestly can’t remember where I came up with 5 years. It might have been from The Motley Fool – they had a big influence on my financial thinking early on.

I think it helps to fashion discipline in our finances, because we automatically know that we will treat each pot of money differently.

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Roshawn @ Watson Inc June 23, 2010 at 5:00 am

Joe, Both the Motley Fool and Dave Ramsey have recommended using the 5-year rule as a guide, so I probably I got it from them.

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joeplemon June 23, 2010 at 7:28 am

@Khaleef and Roshawn,
Thanks for letting me know where you got the 5-year rule. Me? I got it from Dave Ramsey.

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Darren June 23, 2010 at 10:45 am

Joe,

Not sure I quite understand your question. If I was saving for a child’s education 15 years down the road, then I’d feel more comfortable committing some (maybe not all) of the funds to the stock market.

And if I’m 50 and planning to retire at 65, I’d also still have no problem having a good amount of money in the market. People nowadays are in better health, and living beyond the age of 85. God-willing, I’ll be one of them too. So when you reach age 65, you’d still have 20+ years to manage and grow your money so that it doesn’t run out. A logical vehicle within this time horizon is the stock market.

So 15 to 20 years seems to me like a good time horizon to ride out market fluctuations.

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joeplemon June 23, 2010 at 2:52 pm

Darren,

The reason I asked the question about college funding and retirement funding is because you said in an earlier comment that five years, or even ten years seems too short of a time to average out the fluctuations of the market…that fifteen or even twenty might be better. I took those comments to mean that you would feel better setting a 15 year time frame to distinguish between saving and investing. If that is true, then your hypothetical college funding (fifteen years or less) should be all savings and no investing.

My question about retirement wasn’t really a great example because, as you said, someone 65 years old will probably live another 20 years or more, leaving that much “buffer time” to level out market fluctuations. They will need some of the money at age 65, but certainly not all of it. But the college question is one where that money is really needed at that time, with no extra buffer time.

I guess I was trying to better understand what you meant when you said fifteen years. Evidently, based on your answer (particularly about the college funding), you are OK using some investments instead of savings when you are going to need the money in less than fifteen years.

Not trying to put you on the spot…just seeking clarity of how your time frame of fifteen years compares to my time frame of five years. I hope I this makes a bit more sense.

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Darren June 24, 2010 at 10:42 am

No worries, I think I understand what you mean and I’m not trying to step on any toes. I still do feel as though five years is a bit short of a timeframe to ride out fluctuations, but that’s just a personal opinion.

As far as college funding, I do think using a mix of investments and savings is ok. College is at least 18 years down the road for a child, giving plenty of time to put some money in the market and ride out market fluctuations in hopes of better returns. But the key is starting early. That’s why I’m a big proponent of planning as soon as possible. Perhaps the day a child is born, or even beforehand, is a good time to be talking about these issues.

Hope this makes sense as well.

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Carol@inthetrenches June 24, 2010 at 1:42 pm

Wouldn’t U.S. Savings Bonds acheive the higher yield that you’re looking for while minimizing the risk?

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Darren June 24, 2010 at 3:50 pm

Carol, since bonds have a 30 year period until maturity, I don’t think they make sense as a savings vehicle for college (unless you’re planning for an unborn child). They currently have a yield of a bit over 4%, so you’d have to be willing to accept that. On the other hand, 10-year notes have a yield of about 3.5%.

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Carol@inthetrenches June 24, 2010 at 4:58 pm

We must be talking about different types of bonds but I did check with the bank to make sure. The series EE bonds were what I was referring to. A bond that costs $25 today would be worth $50 in 18 years. Yes, that is not nearly as quickly as the old 7 year but would still be worth considering for long term such as retirement or college fund if the intent is saving. They can be cashed earlier if needed. Investing could obviously produce a higher yield with the various risk factors associated. They also have the I bonds that are purchased at face value and earn interest. The rates on those change every April and Oct.

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DON August 19, 2012 at 6:17 am

What about a “savings” plan that builds wealth? As opposed to an “investing” plan and risking what you save. I personally lost 50% of my money in a 403b retirement plan and have not come close to recapturing my loss.
I want a “savings” plan with compound interest with NO risk that will build my wealth!

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Steven August 22, 2012 at 12:17 am

Nice explanation on the difference between investment and savings. While investing can produce high returns, it is true that it involves a lot of risk. It is just right that we must first secure our savings especially that these are the funds that can help us in emergencies. I use the excess money I have for investment and there is little to fear about risks if we know the ways to alleviate those risks.

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Julie @ Freedom 48 August 25, 2012 at 8:50 pm

Good clarification! All of our additional money goes into savings right off the bat. Once the balance in our savings account grows to a certain amount, then we transfer it ($5,000 at a time) into investments. The investments are spread out between RRSPs, TFSAs and a regular investment account. Once the money is in investments, we don’t ever touch it (not until we retire anyways). The savings account however is always accessible and can be dipped into for emergency expenses, big annual expenses or anything like that.

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term paper writers September 7, 2012 at 4:01 pm

Savings often don’t get the great reputation that they should.

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Cedric D'Hue August 14, 2014 at 2:07 pm

Thanks for the article Joe. I note the SEC’s new rules regarding money market accounts will allow custodians to deny requests for withdrawal in times of emergency (http://www.sec.gov/investment/investor-alerts-bulletins/investoralertsmmf-investoralerthtm.html#.U-0IqfldWSo). I assume this makes money market funds less liquid during times of needed liquidity. What are your thoughts?

Thanks.

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