Saving versus Investing. The big question answered.
Welcome to the first in the ‘Foundation level’ learning series. We with a huge problem. Specifically, a problem so frustrating that it drove me to create the website you are looking at. It emerges when we compare saving to investing in bonds or shares. Should I save or invest
In 2019 the best UK one-year savings account pays an interest rate of 2%. However, the current inflation rate is 2%. Therefore savings at the end of the year, can buy nothing more than they could at the beginning.
If you’re as frustrated by this situation as I am. You’re in the right place – I created this blog to offer a solution to this dilemma.
2% feels like a poor deal, but how does this compare with other places we can invest our money? When other factors are considered – like the price swings of stock market investments – does the humble bank account begin to look like a better prospect?
An introduction to the alternatives to savings accounts
Looking beyond savings accounts, the most common investing options are:
Equity (Ownership of a fraction of a company, which gives an entitlement to share of its income and assets to the holder).
- Shares listed on the stock market
- Shares in unlisted private companies
- Units in a fund which invests in companies on your behalf
Debt (The right to be repaid a specific sum, plus interest at a later date)
- Corporate bonds
- Peer-to-Peer lending
Property (Possession of title over an area of land, or the buildings upon it).
- Private investment in land and property (such as ‘buy to let’)
Commodities & other assets (Ownership of other items which may not produce an ‘income’, but whose value may rise over time).
- Collectables, such as wine, art and classic cars.
These are called ‘asset classes’, each category represents a group of investments which have similar characteristics. These alternatives all offer legitimate ways to store wealth and even grow it grow over time. In this article, I will focus on shares listed on the stock market.
Saving v investing in shares – Comparing performance
The table below shows the annual gain or loss in the total value of the 100 largest companies on the London Stock Exchange (known collectively as ‘The FTSE100’).
If we had invested £1,000 in those same companies in 2010, this would now be worth £1,579. That’s an average return of 6.7% per year!
In sharp contrast, £1,000 placed in a 2% savings account for the same period would have only grown to £1,148.
Is this a fair comparison? To find out, we need to look over a much longer period. Credit Suisse, an investment bank, has crunched data which shows that over the last 118 years UK equities have returned an average of 5.5%. This is lower than recent experience has shown, but paints a clear picture of outperformance.
But what about the risks?
The price of any share may fall tomorrow. The value of a listed company fluctuates daily, resulting in good news on some days and bad news on others. Even for seasoned investors, this can be difficult to stomach.
This risk becomes apparent in the most dramatic fashion when a rare stock market crash occurs, in which shares lose a significant fraction of their value in a single day. For example, on 6 November 2008 during the height of the Financial Crisis, the FTSE 100 fell by 5.7%.
If you are the type who would resent even a small loss in the short term, then owning shares is probably not appropriate, as this risk can never be fully eliminated. As you will learn in later articles, it is the higher risk of shares which drives the higher return that shareholders demand.
We revisit this topic in a later article entitled ‘discover your risk profile’ which will provide the tools to understand your tolerances to this risk and discover how you can tweak your investment strategy accordingly.
A wise shareholder does not pray for an unbroken string of gains. A bit like waves lapping on the beach, they accept the ebb and flow of share prices. However over the long term, like a favourable tide, they expect the sea of prices to move gradually in the right direction.
It is when viewed over these long periods, that shares begin to look and feel like a more stable and reliable investment. In the UK, for instance, the stock market has never lost value over any 25 year period (source). This quality makes shares a popular choice for retirement funds, children funds and other long term saving goals. The concept of the length of time you will be investing over (your ‘time horizon’), is a crucial one which we have devoted a later article to.
Why do people fail to invest?
- Crash anxiety from 2008. A survey conducted by Gallop in 2018 (source) revealed that only 37% of under-35s in the US were invested in stocks and shares, compared to 52% in 2007 ahead of the stock market crash which occurred during the financial crisis. The stock market crash during 2008-2009 acted as a deterrent to young investors. What isn’t widely reported is that despite the crash, the US stock market has still delivered an impressive performance. Even if you include the effect of the crash, US shares have gained 8.2% per year since 2007 (source).
- A lack of confidence. Investing concepts can be difficult to grasp, and it is easy to lose yourself in a sea of acronyms and jargon. This confusion works to the benefit of active fund managers and financial advisers, who earn commissions and fees from investors who don’t feel equipped to make investment decisions on their own. For some – delegating this mental effort is a conscious choice they are happy to make. For others – it feels like the only option, despite a nagging feeling that they are being taken advantage of. Tragically, a final group decides that the smoke and mirrors of the stock market make savings accounts the only rationale choice after pondering ‘should I save, or should I invest?’. This website was created to balance the equation and provide more people with access to sound investing principles to help guide them to make better choices.
The costly mistake most of us make
If I asked you to visualise what a disastrous investment decision might look like – what comes to mind? A retiree conned into investing in a worthless company with a chunk of their life savings? A naive investor placing all their money into a single company the day before it files for bankruptcy?
These types of mistakes are both rare and avoidable. Instead, let me paint you an alternative picture of a horrifically expensive investing decision that millions are making. Imagine having £250 to save each month for 30 years, but deciding at the age of 25 to put it in a savings account rather than invest it in the stock market.
In a 2% bank account, those payments over the years would have grown to £123,000.
However, had they placed this in the stock market and generated a typical return of 6%, that £90,000 would be worth £244,800.
The bank saver missed out on an incredible £121,800. Can you imagine the ecstatic celebration of a contestant on How Wants to be a Millionaire winning £125,000? This is the prize on offer to anyone saving £250 per month, which is thrown away by a decision to save in a bank account.
Are shares the solution to poor savings returns?
So far this article has demonstrated that shares have reliably outperformed savings accounts over long periods. However, we have also highlighted that shares bring real risks of price instability. The question of whether shares are appropriate for your circumstances, and what portion of your funds you should invest depends upon many factors such as;
- Risk profile & personal circumstances – how well do you personally deal with the risk of loss, and how do your circumstances impact the risks you can afford to take (for example, if you are in retirement, your inability to earn further income means that extra care must be taken in preserving your existing wealth).
- Time horizon – how long will it be before you need to use the money?
Learning points summary – Should I save or invest?
- Savings accounts pay a poor rate of return which is unlikely to keep up with the cost of living
- There are several alternatives to saving, such as investing in property, shares or bonds. Some can generate returns of over 6% per year.
- Shares are the most popular form of investing and have returned 5.5% annually over the last century and 6.7% over the last decade.
- Shares bring with them the risk of price swings, which may make owning shares too stressful or inappropriate for individuals with an aversion to risk or a short time horizon.
- However, such swings are temporary. Over 25 years, a basket of UK shares has never lost money overall.
- For a saver with £250 or more to put away each month, a windfall of over £100,000+ awaits patient investors after 30 years. A life-changing amount of money is at stake.
- Big Question: Should I save or invest? Answer: as part of a balanced portfolio, you should invest rather than save if you are able to be patient.
Next article: What are Shares and Why do People Invest in Shares?
This article is part of the Foundation Learning Series provided by Financial Expert™
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