What You Need to Know About Saving Money
And why all forms of saving are not equal
“A penny saved is a penny earned.”
Often incorrectly attributed to Benjamin Franklin, the above saying is simply an idiom of common wisdom—assumed to be true because it’s been repeated so often. But can the advice itself stand up to scrutiny?
Before we answer this question, let’s first define the term “saving”.
What is Saving?
Put simplistically, “saving” is: income not spent or consumption deferred.
Yet, “saving” is not the same as “savings”. In financial parlance, these two concepts—believe it or not!—are different things:
- Savings = any increase in assets or net worth
- Saving = method of putting money aside
One can create savings without saving money: by increased wages, purchased assets, or highly volatile (and thus speculative) investments. Put more starkly, savings can also be increased by winning the lottery!
The most common method, however, of increasing savings is by saving money.
Even so, does saving always result in savings? Are all forms of saving the same? Do they all have the same results?
As we’ll see soon, there are wildly different methods of saving money—and not all methods have the desired results.
Reducing Expenses
What people most refer to as “saving money” is the act of reducing expenses.
When someone says “I saved money at the grocery store,” they mean they paid less than the expected expense. For example, if they saved 50% off the price of sodapop then sodapop was obviously bought at a lower price than typical. Yet is money always being saved here?
If the purchaser was not originally planning to buy sodapop, then their expenses have actually increased. This is also true if they planned on buying sodapop but ended up with twice the amount than usual.
While retailers may flog the price of their wares as “saving money,” money is only saved if expenses are actually being reduced. How does anyone discover this? By using the following calculation:
Monthly Expenses ÷ Take-Home Pay = Expense/Pay Ratio
If your Expense/Pay Ratio is greater than 1, chances are you’re living beyond your means and accumulating debt. If it’s less than 1, then you’re building assets and net worth. Hence:
Savings is created when your Expense/Pay Ratio approaches 0!
Emergency Funds
What happens when lower expenses result in higher net worth? If you’re like most savers, the first act is to create an emergency fund—a contingency plan for when “things go wrong”.
Typical reasons for emergency funds are to:
- Avoid the likelihood of falling into debt during a crisis
- Create flexibility during significant life changes (examples: changing jobs or relocating to a new city)
Often, an emergency fund is mistaken for savings. This is not always the case. In actuality, emergency funds are a form of insurance. Like all forms of insurance, it comes at a price.
For instance, if you store your emergency fund under a mattress, you’re destroying value. How so? When factoring the rate of inflation over time, the purchasing power of (for instance) $1,000 decreases. In this scenario, an emergency fund becomes an expense!
This is a large reason why emergency funds are often stored in banks. In banks, the inflation rate is offset by the interest rate. During periods when the interest rate is greater than the inflation rate, an emergency fund increases your net worth.
However, the inflation rate today is higher than the interest rate. Storing your emergency fund in a bank is thus a lower expense than storing it in a mattress — but it’s still an expense.
Just like all expenses, one should always try lowering costs. How can this be done? By following these guidelines:
- Cap your emergency fund. Your fund should only compose 3-9 months of your expected expenses.
- Before creating your fund, define what counts as an emergency. If your tablet breaks down, is this an emergency—or is it an inconvenience?
- Understand how your emergency fund differs from other forms of insurance. For example, employment insurance (EI) exists in case of job loss. An emergency fund helps while applying for EI, but it should not be seen as supplemental EI.
After your emergency fund is firmly established, you should look at how saving money can also double as investment—converting into real savings.
Investment-Grade Bonds
In the financial world, there’s two types of investments: equity and debt. Equity usually takes the form of shares, and debt takes the form of bonds—including (as it were) savings bonds.
In other words, when you buy bonds you are lending money.
But wait. Isn’t lending money inherently risky? Yes, but the risk varies. Before we discuss the risk of bonds, we should first discuss why debt is less risky than equity.
When you buy equity—whether on the stock market or in real estate—there’s no guarantee your principal (e.g., the value of your initial investment) will be preserved. The stock market, for instance, is notoriously volatile. The price of a company’s shares may fall as often as it may rise.
On the other hand, your principal is promised to be preserved when you buy bonds. But more importantly, not only do bonds pay you back, they pay you back with interest!
As hinted previously, bonds may be less risky than stock market shares, but they still have risk. If you’re buying bonds from an entity nearing bankruptcy, it is very possible they’ll default on their debt—meaning you’ll never be repaid.
Acknowledging the intrinsic risks, there’s a broad difference between investment-grade bonds and speculative-grade bonds. Investment-grade bonds almost always preserve the principal. Speculative-grade (a.k.a., “junk”) bonds, meanwhile, may not—and hence offer higher interest rates as an incentive for you to buy them.
How does one know the difference between investment-grade and speculative-grade bonds? Credit ratings agencies do analysis, and provide the following assessments.
As seen in the above chart, variance of an “A” rating is considered investment-grade, and thus exceedingly likely to guarantee the principal investment.
Just who offers bonds? Corporations—but also governments. In fact, governments are safer than corporations. This is because—unlike corporations—governments have an advantage: the ability to print money.
If you buy a government savings bond, your principal is guaranteed if you pay at the face value price. Keep in mind a few x factors, however:
- Typically, interest rates for bonds are at a fixed interest rate until they mature.
- Governments periodically adjust interest rates even as interest rates for bonds stay fixed.
- Therefore, the aftermarket price for government bonds tends to fluctuate.
Selling a government bond before its maturity date may result in losing your principal. Yet if you hold it until it matures, you are guaranteed money being repaid in full—along with a fixed income over a lengthy period of time.
The Best Advice on Saving
Benjamin Franklin never said, “A penny saved is a penny earned.” Yet, he did say something more profound:
An investment in knowledge always pays the best interest.
Not all money-saving creates savings. Money-saving may even destroy value. Even so, thoughtful saving—properly executed—will create the desired results: growth in assets and net worth.
The best arsenal in money-saving is a cohesive money-saving strategy. Without a strategy, saving will not result in savings.
