Saving vs. Reinvesting: Achieving a Balance

by Kenneth Green

Saving and reinvesting. In today’s culture of heavy debt loads and negative savings rates, these two words might reflect the stuff dreams are made of. When they are used in conversation, they are often applied interchangeably.

In a theoretical sense, they are similar in that practicing each requires delayed gratification. By saving or investing, we put off from today with the hopes of enjoying more tomorrow. However, it is while considering the amount of enjoyment we can experience tomorrow where the two paths diverge.

 

It Makes Sense to Save

Saving usually refers to financial vehicles like savings accounts and money market accounts. We feel good about these types of savings because they are often guaranteed and typically provide a modest return.

Every portfolio, whether in our business or personal affairs, should have a component of savings to weather the emergencies life presents or to fund planned short-term needs. 

Once a savings fund is established, investing or creating an investment portfolio, is the next natural step in the process of managing wealth. Investing most typically refers to a wide range of alternative assets such as stocks, bonds, real estate or commodities.

With this range of alternatives comes risk. For example, market values and returns can and do fluctuate as well as some assets being more liquid than others. In exchange for the additional risk comes the expectation of higher returns, returns that will exceed inflation by a significant margin.

 

It Makes Cents to Invest

For this discussion, let’s focus on stocks and bonds. Lacking an ability to predict the future, we can at least infer what lies ahead based on what has come before. According to Ibbotson Associates, inflation between 1926 and 2004 averaged 3%. Over the same time frame, bond returns averaged 5.4% and stock returns averaged 10.4%. These returns provided a margin of safety to ensure that investing proved fruitful.

Where did our cash and savings instruments end up? Using T-bills as a proxy for savings accounts, we would have enjoyed a 3.7% return. While surpassing the inflation rate, it doesn’t provide nearly the margin of safety as that of a ‘diversified portfolio’ of stocks and bonds. 

 

Diversify, Diversify, Diversify

Depending on investment constraints and objectives, one can manage the amount of risk and consequently, the expected returns by building a diversified portfolio of assets. Often the typical investor’s initial exposure to a “diversified portfolio” is from a family of mutual funds. Mutual funds allow an investor to create a portfolio matching their risk tolerances and return expectations. As the portfolio grows in size and the needs of the investor become more complex, the benefits of transitioning from mutual funds to more individualized portfolio management services becomes evident. 

Savings and investing are not an either/or proposition. Rather, they are each integral tools we need to help us reach both our short and long-term financial objectives.

Building a savings fund for our short-term financial security is often straightforward and a matter of execution. With regard to planning for our long-term financial security, we cannot stay safe, warm and snug and hope for the best in the same kind of low, or no-risk assets. Like a successful entrepreneur, we must accept a certain measure of risk and invest in our futures. By doing so, we can raise the odds of reaping meaningful financial returns and ensure that our sacrifices today will provide fruits for tomorrow.

Kenneth Green is vice president of Mitchell Capital Management. He can be reached by phone at 816.561.4629 or by email at klg@mitchcap.com.