We tend to use the terms savings and investment quite interchangeably. Actually, there is a vast difference between the two. Savings are just money kept aside for a rainy day. So the money you have stacked in your bank savings account or a liquid fund is all examples of savings. Investments are all about wealth creation over the long term. Nobody is really talking about doubling your money in 2 years. Investing is a disciplined and systematic approach to make your money work harder and compound into a larger corpus over a long period.
The difference between savings and investment is best captured by the US Securities & Exchange Commission (SEC) in its website https://www.sec.gov
"Savings are usually put into the safest places or products that allow you to access your money at any time. Savings have almost zero risk of erosion and therefore the returns on savings are also extremely low."
"Investments entail a greater chance of losing money than when you save. The money you invest in equity and mutual funds is not insured by the government. But that is a risk you take to earn higher returns and compound wealth over a period of time"
Comparing Savings and Investments and how they create wealth..
Let us compare the wealth creation capacity of savings products versus investments products. Let us measure the wealth creation in terms of the number of times the core investment outlay gets multiplied due to the power of compounded.
Savings ProductsInvestment ProductsParticularsBank SavingsLiquid FundsBalanced FundsEquity FundsMonthly OutlayRs.10,000Rs.10,000Rs.10,000Rs.10,000Time Period20 years20 years20 years20 yearsAnnual yield4%6%12%16%Total OutlayRs. 24 lakhsRs. 24 lakhsRs. 24 lakhsRs. 24 lakhsValue after 20 YrsRs.36.80 lakhsRs.46.44 lakhsRs.99.91 lakhsRs.174.95 lakhsCorpus/Inv ratio1.53 times1.94 times4.16 times7.29 times
The above table shows why the investment products create greater wealth over a longer time frame. As you stay invested for long at higher rates of return, your principal and your return on principal keep getting reinvested at higher yields. That is what makes the power of compounding. Remember, the difference between savings and investments are a classic trade-off between risk and liquidity in determining returns. Compared to savings products, investment products are more risky and are less liquid. That is the reason they yield higher returns compared to savings products. Of course, investment products also tend to be more tax friendly compared to savings products and if that is factored in then the wealth gap would be much higher.
Why savings are important..
To begin with savings and investments are not discrete subjects to be compared or contrasted. Let us understand the critical role that savings play..
Savings are a must for your emergencies. You could lose your job, you may plan to start your own business or you may be hit by a medical emergency. In these circumstances you need liquidity and a liquidity back-up to fall back upon. That is why it is always advisable to hold 5-6 months of your monthly earnings as liquid savings. In fact, it is the comfort of savings that allows you to invest more prolifically.
Secondly, the process of investing begins with savings. Let us first understand savings as the difference between earnings and expenses. Here is where the first steps towards wealth creation begin. You must not look at savings as the residual but look at expenses as a residual. As your income grows, keep raising your savings target and work your expenses accordingly. Out of the money you save, allocate a small portion to liquid assets like bank deposits and liquid funds and the rest to long term wealth creation. That is why savings are so important.
A good savings mix ensures that you do not have to break your investments at a future date unless the situation is absolutely demanding. Breaking your investments means that you miss out on future wealth compounding opportunities. Forced breaking of your investment could also have negative implications for your tax liability and to your long term goals pegged to these investments.
Investments hold the key to your future..
To put it mildly, investments bridge the gap between your dream and the reality. Look at the two investment products in the above table. A balanced fund at 12% returns is able to multiply your investment 4.16 times but if the returns are higher at 16% then the investment is multiplied 7.29 times. That is the big difference that the power of compounding makes. So here is why investments are so critical to your long term financial goals..
Over a long time frame the risk inherent in investments tends to get neutralized and that works in favour of the risk-return trade-off of these investments. Even on a risk-adjusted basis, these long term equity investments tend to be much safer and more prolific.
The investment in equity related products has two key advantages. Unlike debt, equity is best positioned to overcome the risk of inflation over a period of time. Secondly, a diversified product like a diversified equity fund is structured to capitalize on different economic cycles alternatively over a longer time frame.
Normally financial planning begins with a conservative estimate of equity returns. Over the longer run, they actually tend to perform much better. That means; the funding gaps in your plan automatically get taken care of. That is very important considering that quite often your outlays cannot keep pace with your rising needs. That is where compounding comes in handy and that is why investments actually matter!