Wednesday, December 17, 2008

The Difference Between Saving, Investing, and Gambling

Let’s take a look at the definition of each of the above words from

A Reduction or lessening of expenditure or outlay: a saving of 10 percent

To commit (money or capital) in order to gain a financial return: investing their savings in stocks and bonds.

To stake or risk money, or anything of value, on the outcome of something involving chance: to gamble on a toss of the dice.

The above definitions shed some light on the differences of each word, but let me elaborate on them a little further.

In finance, saving would refer to setting aside money for the future. Forgoing consumption today to have more in the future. It does not mean buying shoes on sale. The major difference between saving and investing in my opinion, is that saving involves little or no chance of loss to the principle. Things like Money Markets, bank CDs and U.S. saving bonds. 

Investing on the other hand has both the potential for gain or loss. Because of the potential for gain or loss many people think of investing as gambling. They say things like, I lost money in the stock market before, and I rather take my chances at the casino. This is simply not true and I will explain why.

There are major differences between the two. Gambling involves either total gain or total loss. Also you can put up a small sum for a large payout, like the state lottery. Investing is more of a process in which you put up relatively a large sum of money compared with gambling, and it can take a long time for your investment to grow. Your money is placed into something, whether it is companies, real estate or a promissory note. You rarely lose all of your money when investing. With gambling one party wins and one party loses. With investing and saving many parties benefit from the transaction. For example, I put money into a saving account at the bank, the bank pays me interest and I make money. The bank loans the money to you for a new car, you get a car. The bank and the dealership make money. If the dealership deposits that money back into the banking system the process starts all over again.

My deposit- $20,000

Bank lends you my-$20,000

You give dealer $20,000 for a car

Dealer deposits same-$20,000

the bank lends the same $20,000 again and the process goes on and on. So my $20,000 deposit has provided $40,000 in loans or money into the financial system so far. This is an over simplified example of the multiplier effect to make a point. The bank has reserve requirements for safety and to meet withdrawals. A different process happens with stocks and bonds but has somewhat of the same effect. When investing, you are a contributor to the capital markets. Gambling may be fun but it is not the same as investing. As far as I can tell in the long run investors come out way ahead.

So which are you a saver, investor, or gambler, two of the three or all three?


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