The difference between saving and investing
Saving and investing are often used in articles as synonymous terms, but in fact they are quite different in a number of ways. Here we look at those differences and why it’s important to consider both as you put money aside for the future.
Saving means putting money away in a largely risk-free account. It usually comes with the chance to earn interest on the capital you save so that it grows over time. Examples include savings accounts with banks or building societies, or savings vehicles like cash individual savings accounts (ISAs), where the government provides tax benefits to encourage saving.
Investing involves putting money into an investment vehicle or buying shares, or other assets, in the hope of growing the capital over time. The main difference compared with saving is that investing involves a greater level of risk and there’s no certainty you will grow your capital. Indeed you may lose some or all of your investment if things go badly. Investments include assets like shares, bonds, exchange traded funds (ETFs), property and investment trusts. There are also investment accounts with tax advantages, like a stocks and shares ISAs or a self-invested personal pension (SIPP).
It’s important to have savings and investments
Everyone should have rainy day savings, perhaps equivalent to three months income, for unexpected bills and emergencies. You might also want to save for days out, holidays, or special treats. Or you might want to save up for your next phone, tablet or laptop.
All of these goals require liquid cash, able to be called on quickly if not instantly. The quicker you need it, the lower interest rate you can expect. If you are prepared to tie the cash up for two, three or even five years, the interest rate usually goes up, although in today’s low interest rate world, not by much.
But what if your savings goal is longer-term, such as education costs for your children or grandchildren, that holiday of a lifetime, or simply your own future nest egg? That’s when investments may deliver bigger returns and grow your capital rather than rely on interest payments.
As long as your time horizon is long enough to smooth out the market’s ups and downs, then historically investing has delivered better returns than saving.
Tax efficient saving and investing with ISAs
The UK government introduced the tax-free ISAs, with the option of cash or stocks and shares, in 1999. The annual contribution limit started at £3000 for cash and £4000 for stocks and shares, but has more than doubled since 2010 to stand at £15,240 for either cash or shares.
So which type of ISA has done better?
According to calculations by Fidelity International, if you had invested the maximum ISA allowance each year since the birth of ISAs - a total of £101,520 into the FTSE All Share index, you would be sitting on a gain of over £65,000. If, however, you had put the same money into the average UK savings account over the same period, you would have made barely £5000.
‘That’s a difference of over £60,000 - too big for any sensible saver to ignore,’ says Fidelity.
A lump sum of £1000 left in an average cash ISA since 1999 would by now have earned you about £204 in interest. Yet four out of five ISAs are still cash ISAs, with stocks and shares ISAs having fallen from 23% to 20% of total accounts over the past ten years.
Invest for your children or grandchildren
Junior ISAs suffer from the same bias. These can only be accessed by the young beneficiary at the age of 18, so depending on when they are started there could be up to 18 years of contributions. But the junior ISA offers the option of cash as well as stocks and shares, and it is the cash version that is taken up by most parents or grandparents – over two-thirds of them are perhaps shortsightedly saving, not investing, for a long-term goal.
The pay-in limit here is £4080 a year - a hefty £340 a month out of the pay packet. Typical contributions are far lower. But even at £100 a month, it makes sense to harness the power of the market.
Over five years, £100 a month would grow to £6890 and over ten years to £14,375, assuming growth of 5% and average charges, Fidelity says.
The investing alternative cited by Fidelity, the FTSE All Share index, is not the only option. Investors wanting only moderate risk don’t need to be invested entirely in the UK or entirely in shares. These days, it is possible to buy directly into other parts of the investment universe, from global or US equities to smaller companies, property and commodities, and to assemble a diversified portfolio of asset classes using ETFs. Diversification spreads investment risk as when one asset is performing badly, others may be performing well so offsetting the underperforming asset. It’s an important investment technique. Watch investment expert Andrew Craig, author of How to Own the World, explain the power of diversification.
Bolster your potential returns by investing
Even the best online savings accounts pay barely 1%. Given that inflation is now racing towards 3%, that means savers are effectively losing money all the time.
No wonder that Lloyds Banking Group shares have become such popular investments on trading platforms – Lloyds will earn you an expected dividend worth 7.4% next year at the current share price.
But if buying individual shares is too risky for you, note that UK equities as a whole returned 16.75% last year, following returns of 0.8%, 1.18%, 20.8% and 12.3% in the previous four years. US equities have delivered between 7.25% and 33.5% since 2012. Real estate returned between 2.45% and 25.2%. Global equities would have given you 3.4% in the lowest year, and 29.4% in last year’s bumper show.