You need to know the difference between saving and investing - Alexander Forbes
To save, you have to spend less than you earn. The difference can be saved in a safe place for upcoming expenses, such as a wedding, the deposit on your first home and an emergency fund. Your savings need to be easily accessible, as savings are normally for goals you want to tick off the list in the next one to three years, or for unexpected expenses. Because of the shorter savings period, the savings growth will be lower compared with a long-term investment, but the growth will be stable and predictable.
A savings account is a great place to park your money for a while, but if you leave your savings there for too long, you might find that you can buy a lot less in the future due to the eroding effects of inflation. You need to invest to earn inflation-beating returns.
At some point, all of us want to stop working, or perhaps become our own boss. By investing, you are buying assets that can generate an income in the form of interest, dividends, rental income and profits. To earn an income, you invest in bonds, stocks, property or a business. The cost of higher long-term investment growth is short-term uncertainty, as economic conditions change and prices move up and down over the short term.
With a longer investment period, you earn higher returns, because of the power of compounding growth over time. Investing requires patience and tolerance, as your investment might be locked up for a long period as wait for the magical effects of compounding growth to increase your assets.
To illustrate the case that you should save for the short term and invest in the long term, let’s compare an R10000 investment in a savings account at an annual interest rate of 6 percent to the same investment in a local share portfolio over the past three years.
After three years you would have had R11910 in your savings account, and your share portfolio would have not grown at the same rate, as the market has barely moved over the past three years.
However, if we extend the investment period to 20 years, the money in your savings account would be R32071 compared to R105450 in the share portfolio at an assumed growth rate of 12.5 percent.
You can turn spending into saving, by deciding what your goals and planned expenses are for the next one to three years, and what you want your life to look like in 10 or 20 years.
Looking at your short-term goals, start by saving 10 percent of your income towards an emergency fund big enough to cover three to six months’ worth of expenses. You can use a savings account or a money market unit trusts fund to store your savings.
Depending on your goals you can start investing in your child’s education or your retirement. For a long-term investment, you can use tax-free savings accounts, low-cost property unit trusts or retirement annuity funds.
Jaco Prinsloo is a financial planner at Alexander Forbes.