By: Gabriel Botha
As kids, we were told to save — in our bank account or our piggy bank. We didn’t realise then that if we had invested our money instead, we would have been further on the path to unlocking our financial freedom.
As July is National Savings Month, it is important to prioritise financial education, as many people tend to view saving and investing in the same light due to the similarities between them. One of the most notable similarities is that both involve saving towards a future goal. However, the key difference between the two lies in the asset class you invest in. Investing involves putting money into more risk-tolerant assets that have the potential for higher returns, while saving is limited to cash-only assets (more risk-averse) that have lower returns.
What is the difference between saving and investing?
When considering risk and returns and where asset classes fall on the spectrum, it would be as follows:
The most conservative asset class would be cash. You would also receive the least amount of growth on cash investments. Moving up the risk curve would be other short-term fixed-income assets, then bonds, property and equity, generally seen as the riskiest asset class but it has proved to be the best long-term outperformer of inflation and creator of wealth.
At the end of the day, it comes down to how hard your money is working for you. Your money needs to equal the inflation rate to ensure you’re not getting poorer and that you outpace the inflation rate if you want to grow your wealth.
We look at practical examples of the asset classes, with inflation set at 5.2%. The cash (Stefi) 12 months return to the end of June 2024 is 8.22%, providing a 3.02% return above inflation. The SA Interest-bearing money markets 12-month return to end June 2024 is 8.7%, providing a 3.5% return above inflation. When considering Global Equities, the12-month return to end June 2024 is 12.87%, providing a 7.67% return above inflation. Over the long run, the outperformance of inflation is what drives our wealth.
In our higher interest rate environment, we have a scenario where money in the bank almost keeps pace with inflation. Over the long run, money in the bank struggles or does not keep pace with inflation as inflation is often higher than the returns you receive in a normal bank account. This means you are not creating wealth by keeping money in your bank account.
As you start taking on more risk and investing in riskier asset classes you will notice your return after inflation increases, effectively creating wealth.
Rule of 72 and rule of 114
The risk versus return trade-off can be evaluated using the rules of 72 and 114. The rule of 72 calculates how long it will take for your money to double, given a rate of return. Take 72 and divide it by the rate of return that you can expect. If you can invest at 10%, then take 72/10=7.2. This means it would take 7.2 years to double your investment at a rate of 10% a year. The rule can also be used for inflation to see how long it would take for your money to halve in value because of inflation. The rule of 114 calculates how long it takes to triple the value of your money by using the same method used for the rule of 72.
On your journey to financial freedom, it’s important to ensure you’re outpacing inflation by looking at the various asset classes and the value they offer in terms of their long-term outperformance. How hard is your money working for you?
* Botha is the retail business development at Prescient Investment Management.
PERSONAL FINANCE