Understanding the Difference Between Saving and Investing
There is, of course, a big difference between saving and investing. There are also different time frames and goals within the overall broad categories of each of saving and investing. There is also something of a continuum between these two categories. The approaches and the reasonable expectations and the risk differ.
The meaning of Saving:
To save money is to set money safely aside for future use. In a primitive world without money or in the animal kingdom one might save or set aside food for use in winter or in times of shortage. The goal would be to preserve the food and keep it safe from loss, theft or spoilage. In this example there would be no expectation that the saved stockpile of food would grow in any way. In the modern world saving money is the equivalent of the ancient practice of setting aside and safeguarding food and fuel for future use.
The meaning of investing:
Warren Buffett has provided a definition of investing as follows:
“At Berkshire we … [define] investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power after taxes have been paid on nominal gains in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.” (From Warren Buffett’s 2011 annual letter)
Saving versus Investing:
There is probably no exact description that always differentiates saving from investing because there is likely some overlap when it comes to long term saving versus investing. However, I would argue that the essential difference is that saving should involve zero or close to zero risk of loss of capital even on a temporary basis. Investing will almost always involve accepting that there can (and almost certainly will) be times when capital declines on at least a temporary basis. This risk is accepted in return for a reasonable expectation (but usually not a certainty) of growth in after tax and after inflation purchasing power of the investments over the longer term. If there is not a very high expectation of an ultimate growth in purchasing power, at least on a portfolio basis, then one has probably entered the realm of speculation or gambling.
A few words about gambling and speculation:
Many people believe that investing, particularly in stocks, equates to gambling or speculation. That is not the case when investing is done properly. Gambling and speculation are different in that there is often an expectation of loss. Gambling and speculation lack the high expectation for ultimate long-term gains that define investing. Gambling and speculation usually offer a small chance of a very high return. However, it is often expected that the full amount risked will most likely be lost. But this is accepted in return for the possibility, usually very slim, of a big pay off.
Preservation of Capital:
We live and certainly save and invest in a monetary economy. When it comes to preserving capital and understanding what is meant by preservation of capital we need to understand some distinctions.
Preserving capital in terms of dollars or units of any currency is different than preserving capital in terms of purchasing power. In the short term, barring hyper inflation, the two are the same. For shorter terms (and the definition of “short” depends on the level of inflation) it is sufficient to preserve capital in terms of dollars and to not worry about the decline in purchasing power of the dollar since such decline is expected to be very small in the short term. In the longer term whether we are saving or investing we should be concerned about preserving purchasing power. If you have preserved a thousand dollars for thirty years in a safe, it is very unlikely that this is satisfactory if the purchasing power of each dollar has fallen substantially.
Given a spectrum between saving and investing, and given a low inflation world, I have laid out in a table the different categories and their characteristics, as I see them — and the categories and time frames are necessarily somewhat arbitrary and subjective.
|Category||Goals concerning return||Concern about Preservation of Capital||Willingness to Accept short-term volatility(loss)||Concern about Income Taxes|
|Short Term Saving (under one year)||Unimportant, some level of interest would be welcome but is not required.||Safety is paramount. Preservation of value in terms of dollars will suffice.||Loss in the monetary value is unacceptable.||With little or no return, taxes are not a concern.|
|Medium Term Saving (one to ten years)||A return sufficient to offset inflation and taxes is desired.||Safety remains paramount. Preservation of purchasing power rather than just of dollars starts to become important as the time frame lengthens and if inflation is more than very modest.||Usually little appetite for even temporary loss. Moderate loss in monetary value may be acceptable if it is known that the investment will mature at a certain monetary value.||It is preferred to avoid taxes but they may be considered unavoidable.|
|Long Term Saving (over ten years)||A return sufficient to offset inflation and taxes is desired. There would often be an expectation of some growth in purchasing power but this expectation is not a strict requirement for a saver.||Safety remains paramount. Since this is long term, preservation of purchasing power and not just the dollar value is important.||Moderate loss in monetary value may be acceptable if it is known that the investment will mature at a certain monetary value.||It is preferred to avoid taxes but they may be considered unavoidable.|
|Short term investing (under five years which may be an oxymoron)||A return sufficient to offset inflation and taxes and also some growth in purchasing power is expected but often may not occur due to the short term.||A very high concern for such safety is probably incompatible with the concept of short-term investing.||Having moved from saving into the world of investing some willingness to accept the possibility of loss is unavoidable.||Strategies to favor lower-taxed investments may be important.|
|Medium term investing (perhaps five to ten years)||A return sufficient to offset inflation and taxes and also some growth in purchasing power is expected but occasionally may not occur due to the relatively short term.||There probably has to be some willingness to accept a loss of capital purchasing power though it is expected that capital will most likely be preserved and grow.||Volatility of the value of the investment is accepted given the expectation of a higher return in the long term.||Strategies to defer taxes and to favor lower-taxed investments are important.|
|Long term investing (ten years to many decades)||An expected long-term average return which offsets inflation and taxes and which offers a high expectation for reasonable growth in purchasing power.||It is highly expected that in the long-term capital will not only be preserved but will grow and perhaps substantially.||Volatility of the value of the investment is accepted given the expectation of a higher return in the long term.||The expected return must be acceptable after taxes.Strategies to defer taxes and to favor lower-taxed investments are important.|
See also our related article for a look at the rate of return and portfolio growth rewards of savings versus investing.
Shawn Allen, CFA, CMA, MBA, P.Eng.
November 15, 2014