Saving v/s Investment
Although used interchangeably, the terms savings and investment differs significantly. Important to note, the term savings refers to short-period investment in highly liquid products that allow the depositor/investor to access money any time or with minimal hassle. Some of the saving based instruments available for the investors are saving account, certificate of deposits, checking accounts,et cetera. Another notable feature of saving is that the money deposited is insured by the Federal Deposit Insurance Corporation (FDIC). Therefore, a saving carries minimal risk as in any condition,i.e. even if the bank defaults, the deposit will be safeguard up to the level of $2,50,000. However, the trade-off for saving comes in the form of low interest for the investor while growth is almost negligible.
On the other hand, investment is done preferably for a comparatively longer period of time and unlike saving, the investment products have high risk-reward ratio. In other words, when we invest, we have a high chance of losing the money, but also a chance to grow our money significantly. Accordingly, there is a trade-off between high risk of investing and a potential for high reward. Important to note, investment is made with the objective of capital appreciation and not income.
Types of Saving and Investment
Bank Saving Account: Low Interest, Highly Liquid, No lock-in period
Certificate of Deposit: Liquid Investment, Low Risk,Higher interest rate than the saving account, Lock in period varies from month to year
Bonds: Fixed Income Security, Varied Investment Risks, Source of regular coupon payment, maturity varies from one year to multiple years
Stocks: High risk investment, no regular payout, highly liquid, no lock in period
Mutual Fund: Diversified Risk, Lock in period from 3-10 years
Risk versus Reward
The world of investment is a lucrative sword with rewards being accompanied by risks. Important to note, risk and return carries a positive relationship where an investor investing in high risk investment products seeks high return. Similarly, if an investor is more risk-averse, he will settle for low risk investment products and low reward potential.
For instance, an investor with age close to retirement will always prefer to keep his investment in liquid and now risk investments such as treasury bills, while a young aged investor or a wealthy investor with high risk appetite
However, investors can manage the risk following the rule of diversification as part of which, they can reduce the portfolio risk by diversifying their holdings amongst stocks from non-correlated risk and thus exposing their portfolio exposed only to systematic risk. Important to note, the weighted average risk of the diversified portfolio is less than that of the individual securities.
Cost Benefit Analysis
Also termed as the opportunity cost analysis,the concept of cost benefit analysis relates to the evaluation of the next best thing foregone. While the concept of cost benefit analysis is widely used in the real-life scenario, the same is also applicable in the investment world. It is considerable that investors will always prefer current consumption and will only forego it, if he is compensation well in the form of appropriate return for foregoing his current consumption. Therefore, investors will only invest his money if the benefit of earning appropriate interest in the future exceeds the cost of giving up the current consumption.
Time Value of Money
The concept of compounding deeply effect our everyday life and this is only a by- product of the concept of time value of money. Important to note, The concept of present value and future value are based on the concepts of time value of money, which states that the value of a dollar earned today is more than the same dollar earned tomorrow. Accordingly, any investor will always demand premium in the form of interest to forego current consumption of money and invest it because of high risk and uncertainty associated with the future realization of his investment.
Therefore, it is because of this reason that the time value of money is the core concept of saving and investment and because of the compounding power of money, an investor will always demand interest to earn and will never invest if he is not compensated for giving up the current consumption.
Practical Application of Time Value of Money
As discussed in the preceding section, the concept of time value of money is deeply embedded in our lives and using the same, we can design our investment decisions appropriately. For instance, assuming that I plan to purchase a house worth $3000000 in 20 years from now, but currently only have $80000 to invest. In order to find whether the present investment amount is appropriate to fund my future investment need assuming an interest rate of 7%, I can use the the concept of time value of money to decide my future investment path:
Future Value= Present Value(1+Interest Rate)^Time Period
= 80000(1.07)^20
= $309574
Therefore, using the FV function it is clear that my investment will grow sufficiently over 20 years to fund my house purchase.
Conclusion
On the basis of the above discussion, we can assert that a rational investor will always follow the risk-reward rule and will ensure maximum diversification of his portfolio in order to reduce risk from his investments. Moreover, following the universal concept of time value of money, every investor will only invest in interest bearing assets.
References
Damodaram, A. (2012). Time Value of Money. New York: New York University.
Security and Exchange Commission. (n.d.). Differences Between Saving and Investing. Retrieved May 24, 2016, from https://www.sec.gov/rss/ask_investor_ed/saveinvest.htm
