Investment Masterclass: Savings vs. Investments

Ian King, Tuesday March 18, 2014

One of the most common topics which we discuss with all of our clients is the vital distinction between savings and investments.

Every individual with accessible capital needs to be aware of this important concept, as in our experience failure to properly consider this issue can lead to major disappointment.

Savings

Savings are quite simply assets that are set to be used to meet either known future expenditures in the short-term or unknown future expenditures (i.e. contingencies).  When savings are considered, the primary concern is usually access to funds and security over the capital, rather than the potential for return on the capital.

Investments

Investments are in fact the remaining assets held to be used for other purposes, i.e. not those which are likely in the short-term. Rather than access to the funds or capital security, here a return on the capital is most important.

Common Mistakes

Crucially, only when savings requirements have been met can you move on to consider investment.  The two common mistakes here are:

  • Using investments to fund savings requirements.  The value of the investment can fall just prior to the need for funds, often giving rise to disappointment.
  • Holding excessive assets in liquid form (e.g. bank deposits) when all conceivable saving needs have already been met.  In this instance the likely investment return over time is likely to be mediocre, often failing to keep pace with inflation.  Such an approach will likely, overtime, significantly reduce the real value of the families’ net worth. In this case excess funds should be committed towards an investment strategy.

Savings Requirements

So what needs to be considered when attempting to quantify one’s savings requirements:

  • Known future capital expenditures, usually those set to arise within the next three years.  Some examples here are a new car, home improvements, education costs etc.
  • An allowance to meet expected shortfalls in regular income against regular expenditures.  Rather than a need which is a one off, in many cases, particularly those people who have retired, require an additional source of investment income to supplement their other sources of income to meet their projected regular expenditures.  Here again, having two to three years’ worth of income requirement held in savings is very prudent.
  • Contingency fund.  This is quite simply a source of funds which is solely held to meet any unforeseen expenditures.  Quantifying the need for a contingency fund is something which needs to be done on a case by case basis. Frequently the greatest determining factor is a personal preference over size of funds. Other considerations should be the security of one’s income in various cases, e.g. unemployment, sickness etc. and how this income would compare against core expenditures (those which cannot be easily reduced).  In such cases a fund equal to at least six months, preferably twelve, expenditures should be held.

Budget Analysis

As I have mentioned in other posts, helping the client navigate the savings versus investments decision is a key role of any financial planner.  A thorough budget analysis can for example, help to highlight the need for both contingency funds but also the shape of any investment income needs.  As is so often the case a failure to plan properly can very easily lead to disappointing results.

As always, if you have any comments please get in touch.

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