After monthly travel, food, and general life expenses (hello Netflix!), most of us know we should be putting away a little something for the future. But in the battle of saving vs investing, where should your money go? Or should it be shoved under your mattress?
Spoiler: it’s not the last one.
The Speed Read:
1. Savings deliver a comparatively low reward (in the form of interest) but they are entirely predictable, and in the EU, guaranteed to be safe up to €100,000.
2. Investments in stocks carry the greatest element of risk, but it's this that means that they can really pay off.
3. Used in combination, you can strike a balance between both keeping safe and growing your money.
Saving vs Investing: How savings actually work
Newsflash: Money sitting in your savings account isn’t actually sitting in your savings account.
A bank is a financial ecosystem, with money moving round — lent out, borrowed and returned — all the time.
In reality, when you put your money in a savings account, it’s actually being lent to other bank customers — perhaps as a business loan that allows a shop to buy new stock, a personal loan for a new car or as a mortgage that allows your neighbour to buy the flat next door.
The truth is, banks are a business like any other, which means they need to make money in order to survive. They do this by charging interest on these loans and mortgages, part of which is then paid to you as a reward for lending the money via your savings account.
Here's an example.
Let's say, your savings account pays 1% interest on €100. You’ll receive €1 as a reward for your investment. If your neighbour borrows €100 as a personal loan to buy a bike, with an interest rate of 2%, he’ll repay €102 in total. Of those €2, €1 will go to you, and the other to the bank as profit so they can keep the lights on.
Which brings us to the bad news: as a saver, you’re not actually your bank’s favourite customer.
In fact, you’re a cost on their balance sheet, albeit still a crucial part of the business as the provider of loan money. Your neighbour and his loan is far more popular, since he represents a profit to the bank.
So how do banks convince us all to provide that crucial capital?
Savings accounts are one of the few investments that have a guaranteed return, delivering you the agreed percentage in interest every year. Plus, there is a deposit guarantee scheme throughout the EU that means your money is completely safe up to a limit of €100,000 (or £85,000 in the UK) so even if the bank goes out of business, your money will get returned to you.
But there’s a flip side to this: when there is little risk, there is comparatively little reward. Interest rates are currently at rock bottom around the world, with many central banks slashing interest base rates to encourage spending, during what is likely to be a significant global recession.
Interest base rates:
Each country has a central bank (or the European Central Bank for those countries that use the Euro) in charge of setting the country’s interest base rate, AKA the interest rate that banks pay them on money they borrow. This is passed on and reflected in how much interest banks charge and reward their customers with. Lower interest rates encourage loans and spending but not saving. This way, lower interest rates means more money flowing around the economy, supporting businesses and employment.
Interest rates are, in fact, so low that they’re being outpaced by inflation, which means if you keep your money in a savings account for 5 years, you’ll be able to buy less with it than you could today.
Take your favourite cup of coffee. If the cost of a €5 euro cup goes up 2% each year, next year it will cost you €5,10 and the following year it will be €5,20. If your savings account only rewards you with 1% interest, each €5 will only increase to €5,05 the first year and €5,10 the second.
Your coffee is costing you a larger slice of your disposable income as the years go by.
The other thing to consider is that when you save money in a bank, you don’t have any say in how your money is invested. If a major fossil fuel company is a customer of the bank, your money may well be used to pay for a new oil pipeline — and you may as well not even know about it. Wells Fargo, one of the largest US banks, lent almost $2 trillion to fossil fuel companies in the three years after the Paris Accord was signed. UK banks Barclays, HSBC and RBS have all helped to fund the Dakota pipeline.
You can see a more detailed breakdown of the biggest culprits in this chart below, which outlines the total fossil fuel investments by the world's largest banks:
That doesn’t mean you’re powerless though — a quick Google search of your bank + “funding fossil fuel” (or another issue you care about) should clue you in as to whether your bank is guilty of this. From there, it’s up to you to decide whether to give them your business.
Saving vs Investing: How investing works
When most people talk about investments, they’re talking about purposeful investing in stocks, shares, bonds and funds.
Put simply, when you invest you buy a slice of a company, and if it performs well, your slice increases in value. So for instance, if you invest in a company that increases its sales by 25%, your share will go up in value. It may go up beyond 25% (or below), since the price is set based on demand: the more people want that share, the higher the cost.
Companies performing well issue shareholders with dividends, often on a quarterly basis. This is simply a lump sum payment, almost like a thank you. It’s set on a per-share basis, which means the more shares you own in a company, the bigger the payout.
Sounds good, right?
But there’s a reason why investments are typically seen as more lucrative than savings accounts, and you’ve probably heard it: investments can go down as well as up.
It's this element of risk which means that the rewards are greater.
There’s a very simple reason people invest: to increase their money, without the need to do something to earn that money. By buying something that increases in value, your money is working for you literally as you sleep.
However, the motivation behind investing depends on the individual, and it’s this that should determine your attitude to risk. The more important the money you invest is to you, the lower the risk you should accept.
For instance, if you’re investing your house deposit in the hope of growing that pot of money, losing it would set you back significantly on the home-owning ladder. Therefore it’s a bad idea to gamble that on risky investments. In contrast, if you’ve unexpectedly come into some money and you don’t have it earmarked for something specific, you can afford to take more of a gamble.
The golden rule is not to invest more than you can afford to lose.
Saving vs Investing: A 40-year comparison
Let’s look at what investing €200 a month for 40 years might mean in a savings account versus invested, with actual data from the S&P Index from 1979 to 2019 (a time period that saw several crashes, including the 1980s recession, the dot com crash and 2017’s financial crisis).
Luc decides to play it safe and invest €200 a month in a savings account with an interest rate of 2%.
Flo decides to invest €200 a month in the S&P 500 Index fund, never selling, and always reinvesting any dividends she received.
Both invest €96,000 over the course of 40 years.
Here’s what happens:
It’s great news for Flo, who can now sit back and enjoy a cool €1.3 million. She's weathered several financial crashes but not panicked, and she’s seen the reward. In contrast, Luc has saved €143,000. It's still a nice amount of money to have — but the drinks are definitely on Flo.
So, to save or to invest?
While the graph certainly looks compelling, it’s worth remembering that savings and investments are not either/or products. They fulfill different purposes, and in an ideal world, you’ll have some of each.
Savings might deliver a lower reward, but they have the advantage of being entirely predictable and — at least up to €100,000 — safe.
Investments carry the greatest element of risk, but it's this that means that they can really pay off.
In this financial market, having a combination of savings and investments can be particularly beneficial, allowing you to ensure one pot of money is entirely safe through bank savings, while a different pot works to deliver you a decent return.
And there’s no time like the present! While interest rates are so low and the stock market is recovering from the crash of earlier in the year, it’s a really good time to consider your financial strategy.