There is an important distinction to be made between saving and investing, and it is one that needs to be understood
by all those who wish to maximise their accumulation of wealth during their productive years. In financial terms, saving generally refers to the putting aside of surplus money in a bank account or in a very conservative
investment like a repurchase agreement (a repo for short). There is very little risk to one's principal in these forms of savings and the returns on them are also small. In fact, in volatile economies the real returns on such forms of saving can even be negative due to high rates of inflation, even though the nominal interest rates may seem high.
Higher risks, higher returns
Investing usually involves taking some risk with one's principal by buying directly into financial securities, either through direct purchases or through pooled
investments like mutual funds or unit trusts. Investments are typically placed in stocks, bonds or real estate, although commodities are increasing in popularity as an asset class. It is important to note that there is a very wide variety of investments available within these four broad categories and the risks associated
with them also vary considerably. Investments are also usually held for longer periods of time and usually the more risky the asset in which you are investing, the longer you will have to hold those investments in order to maximise your returns. The compensation for these higher risks is the higher rates of return that can be earned on these assets.
Saving and then investing For those of us who have not inherited wealth or won a big lottery prize, we usually have to start by saving from our earnings and then begin investing once we have accumulated the minimum amount that is required to purchase our chosen investment. In fact, for many people the more prudent route is to start investing in mutual funds or unit trusts as the minimum amounts required for these pooled investments are usually smaller than what is required for investing directly in the underlying securities. However, once we begin investing, it is vital for us to remember a major difference between investments and savings
and that is that investment returns are not guaranteed.
Our savings accounts, certificates of deposit or repos usually carry fixed rates of interest for set periods of time so that we can easily determine what our savings will be worth one, three or six months down the road. This is not so with investments since their values move up and down depending on the prevailing sentiment in their respective markets. It is the upward movement in the securities which are purchased that will provide the investor with positive returns, but prices will fluctuate and past performance is no guarantee of future success.
Chasing rainbows
It is essential that investors understand this point since it is at the root of one of the most common mistakes that investors make when they are choosing which assets to invest in. Many people tend to focus on assets which have done well in the last year or so, for example, choosing the stocks if the stock market has provided the best return during that period. However, the danger with this approach is that markets move in cycles and the same asset class is hardly ever the stellar performer every year. If investors take all their decisions looking backwards, they run the risk of getting into assets when they are at or nearing their peak and when the risk of losses is greatest. Historical returns are just that -historical - they occurred in the past and chasing those returns is like chasing rainbows - it's nigh impossible to catch them.
Anticipation is an essential ingredient of successful investing because this is what will enable the investor to spot the growth opportunities before the asset prices take off and will allow him to earn attractive returns on his investments. Very often it will involve buying into sectors or asset classes that have not been performing well in recent times but which are poised for a turnaround. Thorough research and a trusted investment advisor can be very valuable aides in making the decisions that will lead to a successful investment portfolio.