Savings or stocks –where should I put my money?

The “Savings or stocks investing” debate is popular, and almost everyone has thought about it before. During the week just ended, the central bank of Nigeria (CBN) reviewed downward, its policy on minimum interest rates on local currency savings deposit (saving accounts), from 3% to 1.25%. This means you are now more likely to lose a majority of your money if left in a savings account for long enough. Don’t believe me? Read till the end.

This singular event has inspired some ideas and thoughts. These thoughts are what we have penned as our contribution to the debate on savings account or stocks investing. In this post, we look to present evidence that should get you off the fence and decide which is better for you. To achieve this, we will investigate:

• The opportunity cost of money
• How savings differ from stocks investment
• Basis of comparison between savings and stocks investment
• Dividend yield.
• Inflation–The influential third party that holds the aces
• Savings vs stocks investing, considering inflation
• Conclusion

The opportunity cost of money–Eat your cake and have it?

Given the three options, the ideal scenario is to allocate percentages of every income to the three opportunities above, prioritizing investing, saving, and finally spending in descending order.

Remember the saying, “cut your coat according to your cloth”? The cloth there is how much you should allocate to spending. Live (spend) within your means and have more to allocate to savings and investing. Once you have enough money saved for the rainy day (being able to cover about six months of recurring expenses if you lose your source of income), then you should allocate every other income to investing.

Now that we have identified how much priority should be given to spending, we need to identify why a lot more emphasis should be placed on investing over savings. Why such an aggressive investing plan? We will soon find out why but before then, let us see how savings and investing differ.

How do savings and stocks investing differ?

Saving and investing often are used interchangeably, but there are some differences. Saving is what you do when you put some money away today in anticipation of an emergency or a future acquisition. Savings are what you call any money that you want to have quick-access to with the least risk of losing that money (I emphasize this because we will revisit this later).

Investing is what you do when you buy assets (stocks, bonds, precious metals, real estate, or businesses) with the aim of making more money than your initial contribution. We usually select investments to achieve medium to long-term goals. To understand the differences between savings and stocks investments, please see the image below:

Basis of comparing savings and stocks

Now that we understand how savings and stocks investing differ, we need to find a basis upon which we can compare the two. If there was no basis for comparison, there wouldn’t be the need to choose between one or the other. So, is there a basis for comparison? Yes, there is.

In the infographic above, we see that both have risks and rewards. To successfully compare between saving and stocks investing, we need to measure the risks and rewards of both. We know (from the infographic) that it is possible to lose some or all of the investment in stocks while savings provide more “safety” as you have a very remote chance of losing your money. How then do you compare the return on investment (reward) for both savings and stocks, and how do you compare them?

Reward for saving

With savings accounts, you keep your money in the bank for a promise of safety and a low return on investment. If you are wondering why the safety of funds comes with a low return on investment, it is because of the principle of risk-return tradeoff. In summary, the principle states that low risk will produce a low return while your investment should compensate you for taking a higher risk with a higher return.

Recall that in the introduction to this article, we mentioned the CBN’s policy change, which means you could earn 1.25% per year for putting your money in a savings account. The 1.25% interest rate is the return on investment (reward) for putting your money ins a savings account. In summary, for saving your money in Nigerian banks now, your return on investment could be 1.25%.

The reward for stocks investing

With stocks investing, you buy the stocks of a company and hope to get compensation in either of two ways. The first way to get compensated for taking the risk to invest in stocks is by capital appreciation (or capital gain). Capital appreciation happens when you sell an asset (your stock) for more than what you paid for it. The second way to get compensation for investing in stocks is by collecting dividends. Dividends are a payment that a company makes to its investors, out of the profit that was earned in a period.

For this comparison with savings rewards, the only option we will consider for rewards on stocks is the dividend payment. This is because it has similar characteristics with savings interest. Some of these characteristics include:

• Periodicity – Dividends are paid periodically
• Rate of return – Communication of a return on investment. With stocks, though, we calculate the rate in arrears, not in advance.

So, when you buy stocks, you expect to receive dividends paid from the company. When the company pays a dividend, they usually announce it as a dividend per share (i.e. for every X shares you have, you are paid ₦Y). Given the dividend per share, we need to convert it to a format comparable with the interest on a savings account. To do this we turn to a common investment ratio—dividend yield.

What is the dividend yield?

Let’s use an imaginary company, company X to explain the concept of dividend yield. Company X’s stocks are trading at ₦25 per share. It declares a dividend of ₦2.50 per share. Its dividend yield is 10%. The dividend yield is simply calculated as – Annual Dividend paid (per share) divided by current Stock Price.

Dividend Yield = (Annual Dividend / Current Price) * 100

To describe it, dividend yield calculates the return on investment in percentage terms that are comparable with the interest rate of a savings account or other yield generating assets.

Now that we understand what the dividend yield is, we need to make some notes. We expect savings accounts to pay interest every year. For comparisons to work, you also need to look for companies that have paid dividends consistently. To do this, we pooled data from our database to identify Nigerian stocks that have paid dividends consistently, say, for the last five years. See the result below:

Now that we have a list of companies that have consistently paid dividends, we have a basis of comparison. We just need to identify what the dividend yields are for a target company and determine whether the difference between the yield from the dividend and the savings interest compensates for the extra risk of the stock investment. There is still one piece of the puzzle we need to consider – inflation.

Inflation – The influential third party that holds the aces

To the uninitiated, inflation is just another word that “experts” throw around to make themselves feel good. Hmm… How far from the truth this statement is! To hit this ball out of the park, let’s use an example.

Source – ebay

If you recognize these images, I am sure that you understand where this is headed. For those that do not recognize these, let me tell you a short story. These are the front and back of a once-popular currency in Nigeria. Fifty kobo notes. Depending on how old you are, this fifty kobo note could have bought you:

• a bag full of consumables (this would cost approximately ₦2,000 today – 399,900% increase in price)
• school snacks and a popular exercise book (this would cost approximately ₦200 today – a 39,900% increase in price)
• a bottle of coca-cola (this would set you back approximately ₦50 today – a 9,900% increase in price)

I know you are convinced there is a mistake in the calculations. You can get your own calculator and try some math skills today. Go on, I will wait for your return. Great! Now that you are back and have confirmed there are no errors, you must wonder what happened. Without wasting your time, inflation happened! Do you want to know what inflation looks like?

Inflation is that beauty that every day, takes a nibble out of your money, irrespective of where you put it. Investopedia defines inflation as the rate at which the general level of prices for goods and services is rising and the purchasing power of currency is falling.

Data provided by Macro Trends

You’re probably asking why I called inflation an influential third party to this discussion. It is because inflation is present in both Scenarios. Whether you keep your money in a savings account or you buy stocks, inflation will take a good bite out of your money. Your aim should be to keep your money growing at a rate equal to or greater than inflation and with the lowest risk of loss of your investment. From the infographic above, this means you need to put your money where it will return a minimum of 12.93% (5-year average of inflation) every year. What did we say the current interest rate on the savings account is again? Hmm….

Savings and stocks in the context of inflation.

As explained in the preceding paragraph, we need to put our money where the return will be equal to or greater than the inflation rate. Anything less than this means inflation is eating away at our investment. To make a case for why we should make serious efforts to not forget our money in savings accounts, let us look at the impact of inflation on both savings and stocks.

The table above shows a list of Nigerian stocks that had positive dividend yields, over the last twelve months. We filtered the list to show only stocks in Nigeria’s financial services sector. The average dividend yield for this sector is 9.73%. Unless drastic events happen across the board, we can reasonably assume that a yield of 9.73% is realistic if one invests in a portfolio of stocks that track the financial services sector (this does not include potential capital gains or losses if price rises or falls respectively).

Recall that we stated that we needed a basis for comparison. Well, now we have one. If you put your money in a savings account today, you can expect to get a return of approximately 1.25% with a negligible risk of loss. If you buy a basket of stocks in the financial services sector, you can also expect to earn a return of approximately 9.73%.

You may say that neither of these two options meets the current average inflation rate. True, but let us see how this plays out. The following image shows what a sum of ₦100,000 set aside today would be worth in 20 years under several circumstances (using the earlier assumptions).

Conclusion

We can see that a savings account only provides an illusion of safety. In reality, the guarantee of getting your money back may be a fantasy (if kept long enough). Considering the historically low rate of interest on savings accounts and the high inflation rate of the Nigerian economy, saving money, that is not for short-term needs, comes with a potent guarantee of loss.

While your stocks investment may come with an inherent risk of loss, it provides stronger insurance from inflation. This example does not account for the effect of compounding your returns or potential capital gains. In reality, a properly structured and monitored portfolio of stocks, when compounded, often provides returns well over inflation.

So, which do you think is better? Want to get started investing in stocks? You are welcome at the Investor Hangout.