When weighing up where to save or invest your money, you will often read that investing your money could generate a higher return over the long run. This principle is repeated so often by financial advisers, stockbrokers, government advice portals and even the pamphlets at banks. This relationship is clearly the consensus, but have you ever wondered why is it the case? Why do investments offer a higher rate of return than saving your money in a bank account?
In this article, we’ll explain why investments generate higher returns without resorting to jargon.
The world of finance is a marketplace
In an open, capitalist economy, people are generally free to spend or save their money how they like. This means that money moves around the economy, being directed to the best products in their class.
Money talks. Few people will choose to eat at a restaurant that charges twice the price for the same food served next door. Therefore by spending money at places that offer the best value, the citizens of an economy are effectively ‘voting with their wallet’ to ensure that the most efficient businesses survive. Any business offering uncompetitive prices will be forced to lower their rates or lose their business.
This results in the preferences of consumers shaping the services and prices offered by businesses.
The same thing happens with financial products such as savings accounts and investments. When looking for a place to store money, consumers will compare the relative cost and merits of each option, and in doing so, they shape the rates of return offered to them.
The characteristics of savings accounts and investments
Before we go further, let’s establish the key differences between a bank account and an investment.
First and foremost, a UK bank account is guaranteed by the government. The Financial Services Compensation Scheme will compensate any UK saver up to £85,000 if their regulated UK banking provider goes bust.
Therefore a bank account is the lowest risk option for your money, as you should still retain your wealth even if the bank goes bust as several did in 2008-2010.
Bank accounts also offer stable rates of return that you know in advance because interest rates are generally fixed.
Some bank accounts require you to lock your money away for 90 days, 1 year and up to 5 years, but other variants offer instant access to funds should you need it.
An investment is a different kettle of fish. An example of an investment is using a stockbroker account to buy units in a mutual fund, such as FTSE 100 Index Unit Trust. This particular fund uses the money to buy shares in British companies. Any changes in the value of the shares held, or income (known as dividends) received by the fund is then passed onto you as the investor.
Investments are traded between investors on the open market every day, and therefore depending on everyone’s changing expectations of future performances, their price will also fluctuate – sometimes by more than 2% in a single day.
Why investments offer a higher rate of return
Returning to our market metaphor, let’s consider what would go through the mind of a shopper as they compare a savings account to an investment opportunity.
- A bank account is a safe place for my money
- I will have certainty over how much I will have saved by this time next year
- I will be able to withdraw my money when I need to.
- The investment feels much riskier
- Its value may move dramatically and I could even lose money in the short run
Without looking at rates of return, the bank account is clearly the preference because it offers savers exactly what they want – security and confidence.
For this reason, a bank doesn’t need to offer a high return to solicit money from the general public. It can offer a much lower rate of return than investments are expected to provide, and still expect to see a queue of customers hoping to deposit their money.
A bank generates profits from offering the lowest interest rate possible to savers and charging the higher interest rate possible to borrowers, so it will naturally offer the lowest interest rate on savings accounts that it can while still attracting enough deposits.
On the other hand, investments on the stock market such as shares must be priced at a discount to provide investors with a good reason to accept a step up in risk.
If a company share was expected to be worth £100 in a year’s time (not guaranteed), then it may only change hands at the price of £90 now. A lot can happen in a year, and therefore any buyer would only want to buy the share at a price that will provide a tempting return if the £100 estimate comes true.
If shares with an expected value of £100 in a years time are valued at £90, then it is obvious why the returns will be generous – they are priced in from the beginning. If an investor bought a share at £90 and sold it after a year for £100 then they have made an 11% return on their purchase.
A justified difference
We hope that this explanation has explained the almost invisible combination of market dynamics, psychology and simple shopping preferences that result in investments offering higher returns than bank accounts.
By simply only investing in assets that appear to offer good returns relative to their risk, investors vote with their money to ensure that this status quo remains.
If the prices of investments rushed skyward, to the point where investors no longer expected to make a clear profit over the next few years – what incentive would any new buyer have to buy shares? Instead, they could put their money in a bank account for a guaranteed rate. Buyers would evaporate from the markets and prices would fall to the point where buyers were tempted back.
The fluidity of supply and demand works to keep prices at a reasonable level that ensures a new investor should have a good chance of earning a decent return at a premium to bank accounts over the next few years.