Nowadays, you can gain almost no interest by saving money on your savings account. On the other hand, significantly higher returns can be achieved over the long term via the stock market.
Having a closer look at the S&P 500 Index over time, which represents the biggest 500 companies of the United States, demonstrates that you could expect an annual average return of about 10%, investing in those companies over the long term. The S&P 500 is weighted by market capitalization and is one of the most important stock indexes in the world.
With an investment in more than 1600 companies from 23 industrialized countries (represented by the MSCI World index), you could expect an average return of about 6.5% in the long-term (The average annual return of the MSCI World Index for the period from 2000 to 2021 is 6.5%).
But investing in stocks is not always the best choice. In this article, I would like to give you a guideline on which amount of your money you could use to save on your savings account and which part of your money you could use to invest.
Only invest money you have not planned to use elsewhere for at least the next 10 years
The money that is not needed in your short or medium-term plans could be invested in the stock market with the aim to achieve a higher return than in a savings account.
When investing in stocks, you should always make sure that you only invest the money you have not planned to use elsewhere for at least the next 10 years. Also, you should not use your short-term liquidity reserves to invest in the stock market or even borrow money to invest it in the stock market. If you invest money in the stock market, which you need for something else in the short term, there is always a danger that the stock market will suffer a price slump at the moment in which you are forced to sell the relevant stocks and you could incur a significant loss. Even if you choose a very long-term investment horizon and invest in companies with major competitive advantages, there can be major fluctuations in the stock market in the short term.
Savings Account for the money you need in the short term
For the money you need in the short term, a savings account is usually a better alternative to the stock market, due to the significantly lower short-term risk, even if you will not gain much interest through your savings account.
It is important to have financial reserves in the savings account or hold it in cash so that you can react to unforeseen events such as unemployment, illness, divorce, major repair work or other acquisition costs, etc. Depending on the type of activity and the security of your job, these liquidity reserves should be at least 6 monthly salaries.
The following table shows the differences between saving in a savings account and investing in the stock market in terms of duration, liquidity, risk and return:
Saving in the savings account vs. Investing in the stock market
Saving in the saving account
Investing in the stock market
Used to pursue short-term goals, for example, to build up reserves for the purchase of a car
Investing can help you achieve long-term goals, you should always invest with a very long-term investment horizon
The money in the savings account is immediately available in cash
It can take a few days until your invested money is available in cash
There is minimal risk in saving compared to investing due to the short-term fluctuations on the stock market
Investing always means taking a certain risk without a guaranteed return. In the event of bankruptcy, you can lose part or even all of your investment
Potentially lower return:
Usually you receive minimal interest on the savings account
Potentially higher return:
Investing has the potential of a significantly higher return than saving money
When deciding how much of your money should be invested in stocks, a particularly important aspect is how high the proportion of your money is that you have already planned to use elsewhere in the short term: For example, if a person has planned to spend half of their money on the purchase of a property and another amount for the purchase of a car, those amounts should not be invested in the stock market. As already mentioned above, this is intended to avoid being forced to sell the stocks at an inopportune time.
Analyse the companies before you start to invest
Before you take an investment decision, you should carefully analyse the companies in which you plan to invest and try to understand the business models of those companies. Here you can find the currently available investment analysis.