November is Financial Literacy Month so I decided to write a series of posts explaining some key things everyone should know about their personal finances. These are things we should be learning in school. If you share this belief, please sign this petition which is a proposal to incorporate financial literacy into the Ontario grade 10 career studies course.
What is the difference between investing and saving money?
When someone says they are saving money, that generally means they are keeping it in a bank account(and hopefully not under their mattress!). This bank account is probably an interest-paying savings account but many people also “save” money in a chequing account, which might pay very low interest or no interest at all.
When someone says they are investing money, that generally means that they are buying some kind of investment product with their money. Examples of investment products are: stocks, bonds, GICs, mutual funds, index funds, exchange-traded funds(ETFs). People buy investment products because they typically generate a return on investment (ROI) which is greater than the interest rate paid by bank accounts.
Can you explain what the terms “interest” and “return on investment” mean and why they are important to me?
Of course. You work hard for your money, so when you have some left over after paying your living expenses, you get to choose where to keep it. No matter where you decide to keep that extra money, the important thing to understand is that whoever takes your money is going to use it to make money for themselves. Since they are using your hard-earned money, they should compensate you for letting them use it, right?
I know this may sound strange, but when you put your money in a savings account at a bank, it’s not just sitting there waiting for you to take it out. The bank takes your money and lends it out to other people to buy cars and houses and anything else they might need. You don’t notice this because whenever you need your money, they just take it from their giant pool of money and pay you immediately.
The bank pays you a very low interest rate for depositing your money, probably less than 1% on average. The lowest rate they charge to lend out your money is around 2-3% these days, which is the interest rate on a mortgage, but they can charge over 20% for credit card interest. Big difference.
Interest is the amount of money paid to you for letting the bank use your money to make money for themselves for whatever period of time you leave your money there.
RETURN ON INVESTMENT
As mentioned above, investment products are things that we buy. So if you buy a stock(share) of Netflix(for example), you now own part of Netflix(a very small part). Netflix is ok that you own part of the company, because they can use your money to run their business. It costs a lot of money to produce, or purchase, quality programming, and sometimes it takes time to make that money back. So for many companies, selling shares of their company is the best way to generate the money they need to buy all the things to make the products that will grow the company and make it successful.
Instead of paying you interest like the banks, Netflix has a few options to compensate you for buying into their company:
- They work really hard and become a really successful company over time. You invest in Netflix when it starts out and buy a share for $10, then 5 years later Netflix is huge and making tons of money so their share price increases to $100. You make $90 if you sell Netflix.
- For being a loyal owner of Netflix, they might decide to pay you a dividend, which is sort of like interest. Dividends are usually profits made by a company that they decide to share evenly with all shareholders, so the shareholders decide to leave their money with Netflix.
There are many types of investment products and returns on those investments but the underlying theme is that you are giving your money to someone else, in the hopes that they will make lots of money with your money, and then give you lots of money in return.
Investing sounds way better(more profitable) than saving. Why shouldn’t I invest all of my money and save none of it?
The answer is mostly risk, but also access to your money.
Investing in Netflix, or any one company, is really risky. What if everyone starts reading books because of some cultural revolution, and no one watches TV anymore? Your Netflix stock is now worth zero. Your hard-earned money is gone. This is where the phrase: “Don’t pull all your eggs in one basket.” applies.
Investing in most anything carries some risk, no matter how much you try to balance your risk by buying a mix of different companies in different industries, because investments are usually tied to companies, and companies can lose money because of so many factors.
The only risk-free investment out there is a GIC or Guaranteed Investment Certificate. But the downside to GICs is that you usually have to lock up your money for 1-5 years to get a return on investment that is just slightly better than a regular savings account.
Bank savings are yours whenever you want them. They have zero risk, because the bank protects them and all savings accounts in Canada are insured by the Canada Deposit Insurance Company up to $100,000, just in case the banks all decide to go bankrupt, which is unlikely.
So I should just keep my money safe in a savings account then. Investing sounds scary!
I see where you’re coming from. I wasn’t trying to scare you, but I do really want you to understand that there is risk in any kind of investing, and if you are really risk-averse, then maybe keeping your money in a 100% safe place is the right choice for you. If you start early and save a lot of money, often it doesn’t matter what your interest rate or ROI is over the years, because you simply have enough. But that’s uncommon.
The good news is that even though the stock market is risky, the past tells us that over time, the ups and downs even out, if you make sure to have a balanced portfolio. The real return of the stock market from 1950-2009 was 7%.
That’s why funds are good, because they are all about balance and trying to mimic the overall stock market and sometimes get better returns. It’s not just a fund full of Netflix. It will have a mix of hundreds of companies in it.
So balance + time = lower risk, and therefore investing is not so bad if you have the time.
But the time factor is important. You don’t buy a mutual fund with money that you are planning to take out in 6 months to go on a trip to Hawaii.
In 6 months there could be a stock market crash and your investment is cut in half. That’s a big deal in the short-term but history tells us that your investment will probably recover and then makeup for the losses. But you need to at least give it 10 years to get back on track. Patience is key.