A common mistake is to not compartmentalize and differentiate between saving, investing, and gambling. It’s an easy mistake because not enough people think it through, and the terms are used interchangeably in our culture. I believe understanding the differences and treating each one differently and separately will help you think clearly and be more successful managing your money.
What is Saving?
Very simply, saving is income that is not spent. Some people would consider investing a part of saving. But in terms of personal finance we will consider a more restrictive definition. Saving is income that is not spent or put at risk. In other words, saving involves money put aside for the future with capital preservation the primary goal.
Examples of Saving would be:
Bank Savings Account, Money Market Mutual Fund, CDs, U.S. Treasury Bills or Savings Bonds.
Items you might be saving for:
Emergency Fund, a car, or an event such as a luxury vacation or wedding.
What is Investing?
Investing is having a claim on an entity that produces a product or service with the goal of profit and the risk of loss. Investing is different from saving because your investment is at risk. While there are many different levels of risk an investor may be willing to take; the primary goal of investing is not preservation of capital but long term wealth building. The best investments have growing cash flow and divide an expanding “pie” among the stakeholders.
Examples of Investing:
Individual stocks, bonds, most mutual funds, most ETFs, etc.
Real Estate used as rental property or for production of goods and services.
Buildings such as factories, office space, retail space, etc.
Investing involves the possibility of profits and losses based on performance of the asset.
Example of Difference Between Saving and Investing
Here is an example where the same asset can be saving or investing depending on where it’s placed. A money market fund can be saving in your emergency fund account, but it can be investing in your investment portfolio account.
A money market fund within your investment portfolio should be treated differently than a money market fund for short term savings. The money market in your investment account serves the purpose of lowering portfolio asset correlation and can be used to buy risk assets when opportunities arise. A money market in your emergency fund is for capital preservations and should not be touched unless you have an emergency.
What is Gambling?
Gambling is accepting risk based on chance. Almost all gambling involves risk that exceeds the expected reward. In other words, gambling usually involves dividing up a fixed pie among winners and losers based on chance. In most gambling there is an additional factor such as costs, fees, or odds that results in dividing a shrinking pie.
Examples of gambling:
Currency Trading of Futures and Options (except hedging)
Commodity Futures and Options Trading (except hedging)
Casino games such as cards, table games, or electronic games.
In all these examples the odds are against you because they divide amongst the “winners” a smaller pie than originally existed!
The Importance of Compartmentalization
Investors frequently get in trouble because they fail to differentiate and compartmentalize these 3 very different activities. An emergency fund should be kept completely separate from your investing activities. As pointed out, even if you have the same asset (i.e. Money Market Fund) in each they need to be viewed and treated differently.
Saving is a passive activity for short term goals. Preservation of capital is the primary goal. A separate account for each goal or activity promotes correct thinking and actions consistent with meeting the goals of the account.
Investing is an active activity and keeping accounts separate from saving accounts keeps the asset allocation and diversification process clear and separated from the fund reserved for capital preservation. Keeping funds separate is sound planning and a risk management concept.
Gambling should never be mixed with saving or investing. If someone chooses to gamble it should be with entertainment monies unassociated with saving or investing accounts. Only monies that individuals are willing to lose should be wagered in a game of chance.
Keeping saving, investing, and gambling three separate activities in your mind and in your account structure will assist you in building wealth. Too many people gamble with investment money, or invest when they should be saving. Differentiating and compartmentalizing saving, investing, and gambling, is an important first step to a successful wealth building plan.