For some people, personal finance is right up there with unblocking the drains. Even when they do get around to thinking about it, they may assume that ‘saving’ and ‘investing’ are the same things, not helped by some in financial media electing to use the terms interchangeably.
Even once this distinction is understood another question is frequently asked: “So, should I save or invest?” Here’s my take…
Don’t go to the extremes
Too much of either is probably unwise. That might sound foolish coming from a Fool who’s committed to becoming financially independent. But hear me out.
Saving — which we’ll regard as building up a cash pile in your standard bank account, or Cash ISA — feels comfortable, but it comes at a high price.
You can access it whenever you want and enjoy up to £85,000 of protection, thanks to the Financial Services Compensation Scheme. But the truth is it’s unlikely to grow much in value over time. In fact, it’s more likely to do the opposite thanks to the eroding power of inflation. You don’t need me to tell you the impact this will have on your chances of retiring rich.
Having said this, the extreme alternative — having all your money in investments — might not be appropriate either. Some assets, particularly equities, can be very volatile and there’s always a chance you may get back less than you put in if you need the money in a hurry. And if you insist on keeping your money concentrated in a handful of small businesses, you may get back nothing at all!
Buying a managed fund may be safer. As the recent debacle involving Neil Woodford’s Equity Income Fund has shown, however, throwing your money at star managers who invest on your behalf comes with no guarantee other than you’ll pay high fees whether they perform or not.
So, here’s what I’d do…
Since we all differ in terms of age, responsibilities and financial goals, there’s no one-size-fits-all solution. Notwithstanding, the worst scenario will always be neither saving nor investing.
The only exception will be if you’re concentrating on clearing any debt (mortgage excluded). This is an eminently sensible thing to do considering the interest on what you owe is usually far higher than what you’ll be able to make through either route.
Assuming you’re debt-free, the next step I’d take would be to build an emergency fund of cash in the highest-paying, instant access bank account as you can find.
Again, we all vary on how much we think is enough. But a rough rule of thumb is somewhere between 3-6 months worth of regular expenditure. This ensures you’ll have enough to respond to any emergencies that life throws, but not too much that you end up compromising your wealth-building capability.
Only having done this would I then contemplate getting involved with the stock market, which research has shown to offer the best returns over the long term.
The amount you invest (and where you invest it) will depend on your risk tolerance. But those just starting out could do a lot worse than buy a low-cost index tracker, or exchange-traded fund that buys stock in companies all over the world. I think this will give you immediate diversification and allow you to sleep soundly at night.
