Saving Versus Investing: Matching Money to Time

Saving and investing are often used as if they meant the same thing. They do different jobs, and putting money in the wrong one is among the most common and most expensive mistakes in personal finance. Short-term money invested in stocks can be down sharply on the day you need it; long-term money left in cash can quietly lose value to inflation for decades. This chapter explains the difference, the one question that decides which a given sum needs, and how to sort your own goals.

Two different jobs

Saving keeps money safe and available. It sits in insured bank or credit union accounts, short-term government debt, or similar places where the balance does not fall. It earns a modest interest rate, and you can count on every dollar being there when you need it. Its job is certainty.

Investing buys assets such as shares in companies, through funds, that are expected to grow faster than inflation over long periods. The value goes up and down, sometimes sharply, and there is no guarantee. Its job is growth, and the price of that growth is that the value on any particular day is uncertain.

Neither is better. A household needs both, and the question is only which job each sum of money is doing.

Time horizon decides

The question that sorts almost every case is: when will I need this money? That is your time horizon for it.

• Within about three years: this money usually belongs in savings. There is not enough time to recover from a market fall.
• Three to five years: a grey zone. Many people keep most of it in savings and perhaps a share in a conservative mix of investments, depending on how fixed the date and amount are.
• More than five years, and especially more than ten: this money can usually be invested, because history shows broad markets have generally recovered from falls over periods of that length, although not always quickly and with no guarantee.

How fixed the goal is matters too. A down payment you need in exactly two years is short-term money. A "someday" fund for a home with no fixed date can tolerate more risk, because you can wait out a bad market.

What the extra return is worth over short and long periods

The case for investing is a higher expected return. Over short periods, though, that extra return is worth surprisingly little, while the risk is large. The examples assume a steady 4% a year for savings and 7% a year for a diversified stock portfolio, which is simpler than reality: in practice the stock return arrives unevenly, with losing years mixed in.

Over 3 years, $10,000 grows to $11,249 in savings and to $12,250 if invested at a steady 7.0%. The extra return is small, and a single bad year in the market could wipe it out several times over just before the money is needed.

Over 25 years the picture reverses. The same sum grows to $26,658 in savings and to $54,274 invested. Time lets compounding magnify the gap, and gives the market room to recover from the falls along the way. That is the whole argument in two pairs of numbers: for short horizons, the reward for taking risk is small; for long ones, the cost of avoiding it is large.

Why short-term money in stocks is a poor bet

Broad stock markets have fallen hard and fast within living memory. In 2007 to 2009, U.S. stocks lost more than half their value, and took several years to return to their previous peak. In early 2020 they fell by about a third within a few weeks. Those falls tend to arrive together with layoffs and tighter credit, which is exactly when people need their emergency fund or a planned purchase.

A household that had a down payment invested in stocks at the start of either period could have faced a choice between selling at a deep loss and postponing the purchase for years. A household that had the same money in savings faced neither. That certainty is what savings are for, and it is worth the lower return.

Inflation: the cost of saving too long

The opposite mistake is quieter. Inflation raises prices every year, so cash that earns little loses purchasing power. What matters is the real return: the return after inflation. A savings account that pays about the same as the inflation rate, before tax on the interest, is roughly standing still or going backwards in what the money can buy.

For a few years that is a fair price for safety. For money that will not be needed for twenty or thirty years, such as retirement savings, keeping it all in cash locks in that slow loss for decades. The real return calculator shows what a given return is worth after inflation and tax.

Sorting your own goals

A simple exercise puts each sum in the right place:

Two refinements help. First, as a goal draws near, money that was invested can move gradually into savings, so that the closing years are not exposed to a sudden fall. Second, an investment portfolio for a long goal is usually a mix of stocks and bonds chosen for that horizon; the asset allocation calculator and later books on the investing shelf cover that choice.