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Investing vs Savings – What's the difference?
Many persons are familiar with saving. As a child, you would set aside money from your allowance or lunch money to buy an item that you were really wanted. That’s savings!
Savings is setting aside money for future use. Usually, it is in the form of cash and earns little to no returns.
Which means that if by the time you are ready to purchase that beloved item the price increases, then you may have to save for a little longer to achieve that goal.
That’s where investing makes a difference.
Investing also involves setting aside money. However, this money will be placed in assets that will increase in value over time. The return on your investment is usually higher than your savings which means that you can achieve your goal faster.
So here are three main differences:
- Savings are usually in the form of cash or cash equivalent and placed in savings accounts. While investing is setting aside money in investment products such as stocks that can have a much higher returns than savings accounts.
- Investing will allow you to keep pace with inflation while your savings may not.
- Investing will grow your wealth as the assets that your funds will be placed in tends to increase in value over time. However, because the rate of return on savings are usually very low, after fees you will not earn enough to grow your wealth.
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What are Stocks?
Simply put a stock is your share of the ownership in a company.
Companies issue stock to raise funds to operate their businesses and the holder of stock – who is called shareholder, will have a claim to part of the company’s assets and earnings. This means when the value of the company increase or decrease – so does the value of your stock.
Stocks are generally bought and sold electronically through stock exchanges – for example in Jamaica we have the Jamaican Stock Exchange (JSE) and in the U.S. we have the New York Stock Exchange (NYSE).
The percent you own in this company is dependent on the number ofshares outstanding. So, for example if you have 100 shares of a company and that company has 1000 shares outstanding then you own 100/1000 =10% of the company.
Some stocks pay dividends. Dividends are regular payments made to shareholder. These payments are paid from the profits that the companies generate. Most companies pay dividends quarterly. Dividends can be paid in cash or reinvested back into additional shares.
Stocks are an integral part of most investment portfolios as they often provide the opportunity for investors to earn income through dividends and generate wealth through the growth in the value of the company that you invest in.
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What are Bonds?
A bond is simply a loan taken out by a company or government. It’s essentially a way for governments and corporations to borrow money directly from investors. Unlike stocks, bonds don’t give you ownership rights – it’s a loan from the bond issuer – which can be companies, governments, or municipality to you the bond holder – the investor who buys the bonds.
When you purchase a bond, you’re agreeing to lend a certain amount of money (called bond principal) to a government or corporation for a certain amount of time. In exchange, that government or corporation agrees to pay back 100% of what they borrowed at the end of the loan period (called maturity), plus the stated interest (coupon rate).
When you buy a bond you receive coupon payments. Coupon payments are the dollar amount of interest paid to a bond holder. The amount is calculated by multiplying the interest of the bond (coupon rate) by its face value. For example, if the coupon rate is 8% and the bond’s face value is $1,000, then the annual coupon payment is 8% * 1000 = $80. Coupons are paid at set intervals called coupon dates.
The face value of a bond, also referred to as the par value or redemption value, is set by the bond issuer. It represents the amount the issuer promises to pay once the bond reaches maturity. The price of a bond can fluctuate based on changes in the market interest rates however the face value remains fixed.
There are two important things to consider when buying a bond – credit quality of the bond issuer and the time to maturity. Just like with any other loans if the borrower is not credit worthy the risk of default – not receiving the coupon payments and/or principal at maturity is high. Bonds with low credit quality tend to pay higher interest rates while bonds with good credit quality pay lower interest rates. Also bonds with longer maturities also usually pay a higher interest rate. This higher rate of compensation is due to the fact that the bondholder is more exposed to interest rate risk – risk that when interest rates go up the value of your bond decreases and inflation risks for an extended period.
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What is an investment portfolio?
A portfolio is a collection of financial investments like stocks, bonds, and cash that are combined to deliver returns to the investor. The percentage allocation across each asset class i.e. stock or bonds is determined by various factors including an investor’s tolerance for risk, investment objectives/goal, and time horizon (how long they want to hold investment before selling).
For example, if you are a moderately aggressive investors, you may allocate 80% of your portfolio to equities and 20% to bonds and cash. Within that 80% portfolio allocation to equities, you can make various
allocations based on the country or region – e.g. 60% to US stocks, 20% to Emerging market stocks. Or you can make factor tilts e.g. 30% large cap stocks, 30% mid cap stocks and 20% to small cap stocks. Within your bond exposure you can make regional/country allocations e.g. 10% US bonds and 10% emerging market or 10% government bongs and 10% Corporate bonds.
Building an investment portfolio can be daunting task for someone new to investing as there are several factors that you must consider. After considering those factors, you are then required to take that information and translate it into a portfolio that meets your investment goal while considering your appetite for risk.
Want to start your building your investment portfolio today, then try our SaviiWealth Investment tool to start building your own investment portfolio.
What are Returns?
Simply put, returns measure the performance of your investment portfolio over time. If your value of investment portfolio increased over time, then you would have generated a positive return if it decreased then you would have generated a negative return.
As an example, if you invested $1000 today and after one year your portfolio has now increased to $1100, you would have made a positive return of 10% ($100/$1000). On the other hand, if you invested the same $1000 today but at the end of the year your portfolio is now $800 then you would have made a negative return of 20% (-$200/$1000).
Knowing the expected returns on a portfolio is a good gauge to understanding whether a particular portfolio will help to achieve your investment goal. However, you should not invest based solely on returns as higher returns are often commensurate with high risk – meaning a portfolio that promising a high positive return can also generate high negative returns.
What is risk tolerance and how does that impact investing?
Simply put, your risk tolerance is how much potential loss you are willing and prepared to handle in your investment portfolio.
Your willingness and ability to take risk are driven by many factors including your age (older investors tend to take less risk as they potentially have a shorter time to recoup losses versus younger investors), your time horizon (a longer time generally means you can take on more risk), your financial goal as well as your overall comfort level in taking risk.
Your risk tolerance lies somewhere on a spectrum from conservative to aggressive. A conservative investor refers to forego potential investment gains to safeguard their investment portfolio against losses
while an aggressive investor is focused on maximizing investment returns and is willing to tolerate significant fluctuations in their investor portfolio to achieve that return.
Higher risk equals potentially higher returns so understanding how much risk you can tolerate is crucial to your investment decision. Investors are often faced with the dilemma of wanting to maximize their returns but do not want to take the commensurate risks to achieve those returns.
With our SaviiWealth tool you will be able to assess your risk tolerance to determine what portfolio makes sense for you.
What is Liquidity and how does this impact my investment portfolio?
Liquidity is how easily or quickly an investor can buy or can sell the assets in their investment portfolio. Liquid assets can be sold readily and without paying an exorbitant fee to get money when it is needed. An asset that takes longer to sell is considered less liquid—or illiquid.
Illiquid assets tend to have higher expected returns (a risk premium) to compensate an investor for the fact that the portfolio may not be able to unwind as quickly as one with liquid assets. Many long-term investors, who may be saving for retirement for example sometimes include illiquid asset such as real estate in their investment portfolio as it offers the potential of additional returns. This is often described as the illiquidity premium as you could potentially earn a “premium” on your return to take on the additional liquidity risk.
Liquidity is important factor you need to consider when building your portfolio. Do you want a portfolio that can be easily converted to cash or are you comfortable taking on the liquidity risk to achieve potentially higher returns?
What is Diversification and how does this impact my investment portfolio?
Diversification is a way to reduce risk in your investment portfolio by spreading your investments across a variety of assets so that your exposure to any one type of asset is limited. This is very important as you do not want your overall return to depend too much on any single investment.
Investments that move in opposite directions from one another (negative correlation) will add the greatest diversification benefits to your portfolio. Different financial assets perform differently in different economic times and as such diversification smoothens your returns. For example, stocks offer the potential for the high returns over time but can fluctuate significantly over shorter periods while bonds can offer steadier returns with a fixed payout but can vary as interest rates rise and fall. Therefore, a diversified portfolio of stock and bonds can smooth out your return over a long time period.
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What is Asset Allocation?
Simply put, asset allocation is the mix of assets within your investment portfolio. That is how much of each asset should an investor include their investment portfolio.
The three main asset classes that are included in portfolio are equities/stocks, fixed income/bonds and cash and cash equivalents. Other portfolios will also include commodities (e.g. oil, gold and other precious metals like silver) as well as alternative investment like real estate. Selecting individual securities within an asset class is done only after you decide how to divide your investments among the asset class. For example after an investor determines how much they want to invest in equities/stocks then determine which stock to buy.
Each asset class has different risks and return potential, so each will behave differently over time. The allocation to each asset class will be determine by various factors including the investor risk tolerance, financial goals and time horizon.
What is Volatility and how does this impact my investment portfolio?
Volatility refers to how much the price of an asset fluctuate over time. The more the price changes, the greater the volatility. For example, a stock whose price can increase by 50% in day but reduce by 50% as well would be considered highly volatile versus another stock who can increase by 1% but also decrease by 1%. Higher stock price volatility often means higher risk and helps an investor to estimate the fluctuations that may happen in their investment portfolio.
However, volatility is not always a bad thing, as it can sometimes provide entry points from which investors can take advantage. For example, in a case when stock prices are declining (downward market volatility) investors who believe markets will perform well in the long run can buy additional stocks in companies that they like at lower prices. On the other hand, if stock price is moving up quickly investors can take advantage by selling out stock that they think have reached their peak prices and the proceeds of that sale can be invested in other companies that represent greater opportunity.
What is Portfolio Rebalancing?
Portfolio rebalancing is the process of adjusting your asset allocation, so it aligns with the initial asset allocation. Over time, asset allocations can change as market performance alters the values of the assets. Rebalancing involves periodically buying or selling the assets in a portfolio to maintain the initial level of asset allocation. For example, if an investor portfolio initially allocated 80% of the funds to equities and 20% to bonds, if the stock market increases this 80% could become 90% of the portfolio. The investor may then decide to sell some stocks and buy bonds to realign the percentages back to the original target allocation of 80% equities and 20% bonds.
What is compounding and how does that impact returns?
Compounding happens when you earn returns on not just your original investment, but also on accumulated returns (or interest) you receive over time – in essence you earn interest on your interest! When you invest, the value of your stocks and bonds may increase which makes the balance in your investment account increase. As long as you leave the incremental growth in your portfolio invested, then your returns have the opportunity to compound even more over time.
As an example, if you invested $100 and the value of your portfolio increase by 10% you will now have portfolio worth $110. If you don’t withdraw the incremental $10 and it stays in the investment portfolio, if next year the market increases by 10% again you now have portfolio worth $121.
How does fees impact my returns?
Fees are the cost associated with investing. This could include transaction fees as well as the cost for managing your investment portfolio. Fees reduce your returns over time. What is even more interesting is the impact of fees on your returns gets even larger if you include regular contributions during the year and a longer time horizon.
See below an example of how fees impact your returns:
Say you invest $10,000, and the annual rate of return on your portfolio is 10% before fees. Over 10 years (assuming no withdrawal) the portfolio will grow to $ $25,937.42 before fees. However, if that same portfolio has an annual fee of 3% your returns after 10 years is now $ $19,126.88. Fees would have cost you $6,810.54 over 10 years.
If we increase the time horizon to 20 years, the portfolio before fees is $ 67,275.00 while after fees the portfolio is $36,583.76. The impact of fees is now exponentially higher at $30,691.24.
This underscores the importance of choosing a cost-efficient way of investing as fees will erode your returns.
If you are looking for a cost-efficient way to build your investment portfolio, check out our SaviiWealth tool.
What to consider before Investing?
Building an investment portfolio can be a daunting task, here are 7 questions you should ask yourself before you build your investment portfolio.
- What is my financial goal?
- Do I understand my risk tolerance?
- How long do I plan to invest?
- What is the cost of investing?
- How much am I expected to earn over time?
- What should I invest in?
- Do I understand what I am investing in?
If you don’t know the answer to any of these questions, then seek trusted financial experts who can help you find the solution.
At SaviiWealth we make investing simple by providing the tools you need to make the right investment decisions. Check out our SaviiWealth investment tool today.