What is the difference between saving and investing?
You may be reading this because you have financial goals and are considering investments as a means to achieve your objectives. However, before you commit money to any investment, you could ask yourself the following questions:
Are my financial goals short, mid or long term? How much capital do I have, and more importantly, how much of this am I willing to lose?
Both saving and investing can help you to achieve financial goals across different time horizons. Saving is the act of safe-keeping your money with the intention of using it in the future. On the other hand, investing involves committing money into investment vehicles in hopes of making a financial gain and can be understood as the process of growing your money.
How does one grow wealth from investing? When the security acquired through investment is sold at a higher price than it was purchased for, investors may profit from the price difference. Another way to get income is through periodic payouts – when investors receive a given amount of the expected investment return over a period of time, in the form of dividends or interest income.
The key difference between saving and investing is that investing involves an element of risk. There is no guarantee that the principal amount can be returned, and before making an investment, investors must be certain that they are willing to take on this risk. Right now, you may be wondering – what could cause you to lose your principal investment?
What prevents wealth growth?
Risk can be understood to be the effect of uncertainty on achieving one’s objectives. To put it in context, risk is what prevents investors from reaching their goals.
There are many types of risk in the risk universe, all correlated and dynamic. The following three risks will be highlighted as these are the key risks that beginner investors like yourself will likely be exposed to, and is not meant to be an exhaustive list.
Before explaining, here are some common investment lingo that will be referenced– securities refer to any financial instrument that you invest in, which has monetary value and can be traded. The market value of a security depends on how investors perceive its worth, which often leads to the price they are willing to offer for trade. On the other hand, the issuer is the institution, company or individual who issues the underlying security.
Three key investment risks
1) Market Risk
Market risk refers to the risk that movement in market prices will cause losses to the investment’s value.
The market value of securities will fluctuate, sometimes rapidly or unpredictably. The value of a security could be due to general market conditions such as real or perceived adverse economic conditions, changes in the general outlook for corporate earnings, changes in interest or currency rates or adverse investor sentiment generally. They may also be affected by the performance of specific industries or sectors, such as changes in production costs and competitive conditions within an industry.
Take real estate investing for example, you recently bought an apartment at its market value of $100K. After your purchase, the government announced plans to replace the existing neighbourhood mall with a manufacturing factory, which is likely to release large carbon omissions, thereby reducing the quality of living. As a result, the market value of your apartment is now appraised downwards to $85K, causing you a capital loss of $15K. However, you will not be making a real loss until you sell the apartment at $85K.
2) Interest Rate risk
Interest rate risk refers to the risk that movements in interest rates will negatively affect a security’s value. A fixed income security’s value will generally increase when interest rates fall and decrease in value when interest rates rise. Fixed income securities with longer-term maturities are usually to be more sensitive to interest rate changes than short-term fixed income securities. Thus, the former tends to offer higher yields to compensate or incentivize investors for assuming the added risks.
3) Credit risk
Credit risk, a fundamental risk relating to all fixed income securities as well as money market instruments, refers to the risk that a security issuer will fail to make principal and interest payments when due. Rating agencies such as Moody’s, Fitch and Standard & Poor’s assess the credit risk of issuers on an ongoing basis, and your exposure to this risk could change accordingly. In the event that the issuer defaults on payment, you receive no payout (reduction in your interest income) or could even lose your entire initial investment!
Issuers with higher credit risk typically offer investors higher yields for this added risk. Generally, government securities are considered to be the safest in terms of credit risk, while corporate debts, especially those with lower ratings, have the highest credit risks. Changes in the financial condition of an issuer, and changes in economic and political conditions in general are factors that could affect the issuers’ credit quality and security values.
Next question you are may be asking, how do you manage those investment risks? There are generally 4 ways to do so –
1) Accept – retain security in portfolio
2) Avoid – not invest in the security at all
3) Transfer – purchase insurance
4) Mitigate – portfolio diversification (mix of different asset classes, such as bonds and real estate)
Ultimately every investor has different investment objectives. An investor’s financial goals shape their risk appetite (how much capital they are willing to lose) as well as their risk tolerance (how much volatility they can accept during their investment period). So, what is your risk tolerance?
What are your investment objectives and risk return preferences?
Without a clear understanding of objectives and risk preferences, you could make the mistake of following a herd instinct, and buying or selling when it may have been better to hold off.
One rule of thumb to remember is that investments seeking higher returns come with higher risks, while the relative safety of lower risk investments also comes with lower returns. Typically the longer the investment period the higher the risk investors will be undertaking. This translates into the potential for higher returns.
Generally, investors should be comfortable with some fluctuation in the value of their investments, especially over the short term.
“An investment in knowledge pays the best interest” – Benjamin Franklin.
Know yourself, know the market and its risks before you make your smart investment! Speak to your financial adviser today!
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