A common mistake investors make is confusing saving with investing and perceiving both as the same activity. This post will help you understand the nuances between these two related but independent activities.
When we do not spend a portion of our disposable income, we save it. The objective of saving should be to meet a short-term goal, one that can be funded primarily with our own money. It might be that holiday you are planning for, a tablet you want to buy or for a rainy day. Since the objective of saving is to meet a short-term goal or contingency that might arise, it is important that the saved amount be available to us when we need it, at short notice. Hence, one should park such funds in minimal risk instruments like liquid mutual funds or short period fixed deposits where the risk of capital loss is zero or next to zero.
On the other hand, we invest to meet long-term goals like funding a child’s education or saving for retirement. Investing involves saving small amounts of money on a regular basis and using it to buy assets that will generate returns over a period of time. Since the goal of investing is to meet a large monetary outflow after an extended time frame, it is prudent to invest in securities that offer a higher rate of return. Long-term bank fixed deposits, mutual fund investments in bonds and equities and stock market investments are all preferred routes for investments. As the monetary requirement is not in the near term, investors should approach the investment goal with a higher risk tolerance and not worry if the investment temporarily drops in value. Usually, any amount that need not be accessed for at least the next five years can be considered for investment purpose.
Rashmi is a 26-year-old finance professional working in a Mumbai-based MNC. Her monthly salary is Rs.38,000 and monthly expense including, EMI towards student loan, is Rs.31,000. She currently has savings of Rs.18,000. She is planning to take a backpacking trip to Rishikesh, expected to cost Rs.40,000, within the next 5 months. So she will need to save Rs.28,000 (40,000 – 18,000) for the same. Considering she is saving Rs.7,000 every month, she will be able to meet the goal comfortably by simply accumulating the amount in her savings bank account or buying units of liquid mutual fund.
Mandrita is a 35-year-old bank executive planning her finances to fund her retirement in 20 years. Her current annual income from salary is Rs.25,00,000, she will not receive any pension upon retirement. Her annual expenses including housing loan EMI is Rs.18,00,000 that will be paid off in 20 years time. She does not have any other major financial expenditure or investments. She plans to contribute a constant amount of Rs.7,00,000 towards retirement fund over the next 20 years. Mandrita feels a retirement corpus of Rs.6 crore will be sufficient assuming a lifespan of 85 years. She has the option to invest either in a bank recurring deposit, debt mutual fund, a Nifty exchange-traded fund or equity mutual fund. Each of these options has different return expectations and risk profile.
|Investment Option||Expected Return||Risk Profile||Amount Invested Per Year||Years Invested||Expected Retirement Fund|
|Bank FD||6.5%||No risk||7,00,000||20||271,77,716.10|
|Debt mutual fund||75%||Low risk||7,00,000||20||303,13,276.90|
|Nifty ETF||12.0%||Moderate risk||7,00,000||20||504,36,709.70|
|Equity mutual fund||13.5%||High risk||7,00,000||20||600,79,989.10|
As can be seen from the table, investing in an equity mutual fund allows Mandrita to accumulate the required funds within 20 years. If she were to adopt any other investment option she will have to either increase annual contribution towards retirement fund or postpone her retirement.
The difference between saving and investing
Whether one should save or invest does not depend on the goal, but on the time involved for the event to occur. So if you have to pay for your child’s college three years from now, it is sensible to invest in capital protection instrument like 3-year bank fixed deposit. If the purpose of the investment is to accumulate funds for post-retirement, which is 25 years away, one should consider allocating a large part of the portfolio to equity instruments. Over longer periods’, equities have the potential for higher return compared to all other instruments. Further investing at regular intervals allows the benefit of compounding to kick in, allowing for greater wealth accumulation.