The difference between savings and investments
With such a vast array of financial products available these days, it's sometimes difficult to draw a clear line between savings and investments.
In essence though, savings are kept in cash and can earn you interest. Investments aim to generate more significant growth by investing your money in other areas such as the stock market.
Of course, investments can go down as well as up and you may get back less than you invest. So while the potential returns might be greater, the risks are higher too.
That said, savings aren't entirely risk-free either, as we'll see below.
The pros and cons of saving
From easy access saving to tax-friendly cash ISAs, there's no shortage of savings accounts on the market - each with their own advantages and restrictions.
Easy access accounts may not always offer the best interest rates, but they do provide the flexibility to take money out whenever you need it - vital for those day-to-day expenses.
Other accounts are geared more towards saving than spending. Many offer a more generous (and often fixed) interest rate on the proviso that your money is left untouched for a set period of time.
In either case, your money is safe in the bank (or building society). It's protected by the Financial Services Compensation Scheme up to the value of £85,000 should your financial provider collapse.
The impact of inflation
In a low-interest savings account, there is a risk that your cash savings may struggle to keep pace with inflation.
In other words, even though your cash balance is steadily increasing, your money may be worth less in real terms as things get more expensive to buy.
To illustrate this, think of two shopping baskets of identical goods - one basket paid for in 1995 and the other paid for today.
Even though the items are the same, you'll pay a lot more for the items today - showing how the money you hold onto as cash can slowly lose its buying power over time.
You can see the potential impact of inflation on your savings in our handy inflation calculator.
The pros and cons of investing
Just as there's lots of different ways to save, there are plenty of ways to invest too, such as investing in funds.
Whatever you invest in, you're usually hoping to grow your money one of two ways – either through dividends (if you're investing directly in shares) or through capital appreciation (the value of your investment going up). Or ideally, through both.
The potential rewards of investing are far greater than cash savings, particularly at times of low interest. However, investments expose you to the risks of the stock market.
Your investment could fall in value rather than grow, and it may fluctuate up and down on a regular basis over the short term.
That's why most investments are made for the longer term - to provide time for overall growth and allow room to recover from any bumps in the road. While you can usually cash in your investments at any time, it's therefore often best to leave your investment in place for at least five years.
As a general rule then, you should only invest money you won't need in the immediate future. Anything you need short-term access to is probably best kept in savings.
Savings and investments – the best of both worlds?
While the investing vs saving debate is often pondered, there's absolutely no reason why you can't do both. Indeed, for many people, the real question is simply how much to save and how much to invest.
To help work that out, it's a good idea to list out your financial goals and set a time frame for each.
- For short-term objectives in the next five years (like buying a car or putting a deposit on a house), a savings account might make most sense.
- For longer-term objectives ten years or more in the future (like saving for retirement), investing may give you the best opportunity to grow your money.
- For medium-term objectives in the next five or ten years - such as paying for your children's education fees perhaps - it comes down to your risk appetite. Savings might offer more security for your money, but investment over that time period could yield greater results.
However you choose to spread your money, it might be wise to keep a separate 'back up' fund in an easy-access savings account. Just in case of any unforeseen circumstances like a broken boiler or a sudden loss of earnings.
Holding back a few months' worth of expenses means you're less likely to be caught short, and lets you save or invest with greater confidence.