Why Investing is Better than Savings

Building up a robust savings account is a great way to prepare for life's surprises, but when planning for your future, investing is essential.

Make no mistake, saving will always be crucial for your financial stability.

But as your emergency fund grows, you may want to invest your surplus cash.

What's the perfect balance of investing and saving? Find out in this article. Plus, learn how to mitigate investment risks and how much of your income to save.

Investing vs Saving Pros & Cons

Here is a quick summary of the differences between saving and investing.

With saving money, you know your funds are always there and won't decrease in value, but they won't really grow either. On the other hand, investing money has risk, but there's potential for more growth, which can help you reach your goals faster.

Why should you put money in a savings account?

"Savings" are simply the money sitting in your savings account. Unlike a checking account, a savings account will usually pay interest and limits your monthly withdrawals to six.

If you have money left over from monthly expenses like rent, bills and groceries, it's wise to put it into a savings account. That way it's still readily available if you need it for emergencies, and it's earning more interest.

Most financial advisors recommend you keep enough savings to cover from six to 12 months of your living expenses.

While having more cash in savings is obviously not a bad thing, your idle cash might be costing you the opportunity to build serious wealth. If you already have your emergency fund in place, read on to find out what you gain by investing.

When is investing better than saving?

While savings accounts are safe and low-risk (i.e., your cash is typically FDIC-insured), the returns are minimal.

Meanwhile, investing offers the potential for strong returns. But it comes with major risks.

Fortunately, a lot of these can be mitigated or controlled by diversifying your investments and establishing a clear investment timeline.

In general, investing is ideal when you can afford to keep that money invested for a while. This is because stocks and/or bonds can generate a healthy return over the long term.

For example, in any given year, the S&P 500 could be up or down 10% (or more). If you invest $10,000 today, there's no guarantee what it will be worth a year from now.

However, $10,000 in a savings account will be there whenever you need it. This is why people often say "cash is king."

But over longer time horizons, the volatility in the market matters less, and returns historically become mostly positive.

Why investing is risky, and how to mitigate risk

Investing involves risk because the market is unpredictable.

Some industries struggle as consumer preferences shift and technology evolves. As a result, some companies will inevitably fail.

When this happens, the investors who own its stock usually lose their entire investment because the company they own becomes worthless.

Bondholders could lose their investment as well, but they usually are able to recover most of their investment. Bondholders are usually the first to be paid when a company's assets are liquidated during bankruptcy proceedings.

How can investing risks be mitigated?
While we can never fully remove all risk from investing, we can avoid a lot of it through diversification. Let's say you invest in an index ETF or mutual fund that holds many different stocks and bonds.

The risk of a few of those companies failing is offset by the many other companies that continue to grow and generate profits.

So, by investing in an index fund or other ETF, you effectively avoid the investment risk of a major bankruptcy.

What to know about investing and recessions

Another risk of investing that is harder to avoid is the overall economy taking a downturn, or even going into a recession.

When this occurs, most companies - even the strongest ones - see lower earnings lower stock prices. This is because consumers become more cautious with their spending.

While it's tough to predict a recession (or avoid its impact to your investments), the good news is that the economy usually recovers and comes back stronger than before.

This is what has always happened historically, but it's never clear how far away the recovery is. In general, the economy and stock market tend to bounce back from recessions fairly quickly. But recovery can easily take years or even a decade.

This is why longer time horizons are ideal for producing positive returns (more on this below).

Why a long time horizon is important for investing

Stock market returns average about 10% per year historically over a 10-year period.

This is why it's so important to have a long-term investing mindset. You want to be sure that you won't need the money you're investing for at least a few years since selling early may come at a loss.

What percentage of income should you invest?

The exact amount you should invest depends on the following factors (among others):

• Income
  
• Age
  
• Expenses
  
• Financial + life goals

After you have built up enough savings, consider investing 10% - 15% of your income that money you were saving each month and investing it in a diversified, low-fee ETF or mutual fund.

If you won't need the money for at least 15 years, it makes sense to put most of it into stocks. If you expect to need it sooner than that, you should consider allocating some of it into less volatile bonds.

What percentage of your income should you save?

As a general rule of thumb, it's good to save at least 20% of your income. These savings can go towards things like:

• Retirement account contributions
  
• Emergency fund contributions
  
• Over-minimum debt repayment

While earning returns is appealing, these savings contributions are crucial for financial security and retirement. They also prevent unexpected expenses from taking a serious toll on your finances.

For your emergency fund, most financial advisors would recommend you have at least six to 12 months of living expenses saved.

This is important because it provides immediate liquidity for you to use in unexpected circumstances, like the sudden loss of a job.

Why are stocks and bonds good investments?

Stocks and bonds are good investments because they give you a lot of control over what you invest in. You can hand-pick the stock or bond that you want to invest in.

But that's not all. Review these advantages of stocks and bonds to understand if they're right for your portfolio.

Benefits of Stocks
The barrier to investing in the stock market has never been lower. Almost all major brokerages have eliminated trade commissions for stocks. So you can now make trades for free.

Plus, a lot of stockbrokers offer fractional shares. This means you can buy just a tiny fraction of a stock if you don't have enough for a full share.

Benefits of Bonds
Bonds are good investments - and a good partner to stocks - because they're less risky and more predictable. You can also hand-pick the bond according to your specific time horizon since bonds have maturities ranging from 1 to 30 years.

The Bottom Line: Investing is the best route to long-term wealth

It's worth reiterating that having a healthy savings account is still paramount and should be your first priority.

After you've built up coverage for six to 12 months' worth of expenses in your savings account, then you should start investing your extra savings to build long-term wealth.

The historical data does not lie: Long-term investors realize consistently positive returns of around 10%/year. Their portfolios can outlast short-term volatility, ride through the waves, and bask in the sunshine waiting just beyond the clouds.