Invest To Reach Your Goals
The best way to look at savings and investment options is through the lens of risk and reward. Bank savings accounts have basically zero principal risk (because they’re backed by FDIC insurance, which, like Treasury bonds, is backed by the US Government). Likewise, the reward is also small, particularly if you do the math to account for inflation. The SEC explains this concept well:
Your “savings” are usually put into the safest places, or products, that allow you access to your money at any time… But there’s a tradeoff for security and ready availability. Your money is paid a low wage as it works for you… How “safe” is a savings account if you leave all of your money there for a long time, and the interest it earns doesn’t keep up with inflation? What if you save a dollar when it can buy a loaf of bread? But years later when you withdraw that dollar plus the interest you earned on it, it can only buy half a loaf? This is why many people put some of their money in savings, but look to investing so they can earn more over long periods of time, say three years or longer. (page 11)
With a savings account, you might lose spending power over time. So, there is risk to being short-term focused with your savings.
The Short Term vs. the Long Term
If you need to spend your money in a month or a year, a savings account might be the best place for it, because you’re guaranteed to get back the the same dollars you put in (known as your principal). When you invest in stocks and bonds, you’re not guaranteed to get your principal back. The fact that you are taking more risk correlates with the result that, while your account balance may fall in the short term, you’ll likely earn higher returns over the long term:
Chart courtesy of Stocks for the Long Run; savings account estimate is ours, based on savings rates roughly matching inflation
The Relationship Between Investment Risk and Return
Why do risk and returns go together in investing? One school of thought among prominent economists is that the market for investments is “efficient.” Let us explain. There’s a lot of publicly available information about the securities and investments one might be looking to buy. Investors have the tools available to understand the varying risks of their investment options. Bigger risks don’t necessarily mean bigger returns, but there are a lot of people (and institutions) investing in the stock and bond markets, and they bid investment prices up or down so that they reflect the real risk and value associated with each investment option.
Saving money for major life milestones – education, retirement, etc. – means saving for the longer term: three, 10, or even 30-plus years down the line. Over these horizons, if your portfolio of stocks and bonds is diversified and allocated properly, you should see considerably better returns than a savings account, because of the extra risk that you take on by owning stocks and bonds. It’s a smart tradeoff to make.