You stash your money in a savings account, so it’s safe — that’s the general assumption, at least.
If you keep your money in an account protected by the FDIC or NCUA, you don’t have to worry about losing it.
While that’s technically true when it comes to your original capital, the truth is that, in real terms, inflation risk could be harming your financial future.
Your money is losing value
A dollar is a dollar, right? Not always.
I remember the days when I could buy a king-size candy bar for about 75 cents. Today that candy bar costs at least a dollar. A dollar during my youth could buy more than a dollar buys now.
That’s the impact of inflation. Over time, the cost to buy various items moves higher. It takes more of your dollars to buy the same thing. One of my favorite tools to illustrate this reality is the US Inflation Calculator.
If you spent $20 on something in the year 2000, in 2016 you would pay $28.08 for the same item.
What does this mean for the money you have sitting in a savings account, earning just 0.9 percent per year? It means that you’re not even coming close to beating inflation.
Historically, inflation amounts to between 2 and 3 percent annually. That means there is a good chance that your money is losing value at a rate that can’t be overcome by what your savings account or money market account pays out.
Even in the current low-inflation environment (year-over-year with the 12 months ending in October 2016, the rate is 1.6 percent), your savings account is inadequate when it comes to protecting your financial future against inflation risk.
All financial choices come with risk
When we think about investment risk, the first thing that comes to mind is a stock market crash or a bad bet on an individual stock. We rarely think about inflation risk.
Inflation risk is insidious because it’s practically silent. You don’t see it at work in your everyday life. It doesn’t get big headlines in the news.
You probably don’t think of it this way, but the reality is that keeping your money in a savings account is a risk. It’s a different kind of risk that can reduce your chances at financial freedom down the road.
In reality, you can’t earn enough over time with a savings account to build wealth. Cash just doesn’t offer big enough returns. And once you calculate your inflation risk, you’re losing money over time.
Think about it: You’ve got a 0.9 percent yearly return on your savings account. The Federal Reserve likes to implement policies with a target inflation rate of 2 percent a year. That means that, in real terms, you’re actually losing 1.1 percent on your cash each year.
Of course, inflation rates, like investment returns, aren’t the same every year. Some years inflation is lower, or even negative. Other years, inflation is much higher than the targets set by the Federal Reserve.
Having some of your money in a savings account makes sense for your emergency fund. However, staking your financial future on building up enough wealth through these accounts is a long-term risk that won’t provide for your future.
You can overcome a stock market crash. Over time, market gains make up for a momentary blip on the trend line. You can’t get over the cumulative effect of inflation risk on your cash accounts without balancing it with higher returns elsewhere.
Overcome inflation risk
If you want to beat inflation risk with your long-term finances, it’s vital to look for better potential returns elsewhere.
One of my favorite ways to fight inflation risk is through indexing. With indexing, you take advantage of a wide portion of the market.
A good example is the S&P 500. Below, you can see the performance of the S&P 500 Index from before 1980 until the end of November 2016.
In December 2000, the S&P 500 was sitting at a little above 1,300. Since then, there have been a few fairly major dips:
- One in 2002, where it fell to right around 800
- Another in 2009, following the financial crisis, to below 700
At the end of November 2016, the S&P 500 Index is a little above 2,200. Buying S&P 500 shares in 2000, and holding them through the market dips, would see you come out ahead today — and handily beat inflation.
There are other ways to hedge against inflation risk and boost your chances of long-term wealth:
- Treasury Inflation Protected Securities (TIPS): These are government bonds that keep pace with inflation. You won’t beat inflation, but you’re less likely to lose your money’s value.
- High-yield bonds: You can invest in high-yield corporate, municipal, and foreign bonds to earn a higher yield and possibly beat inflation.
- Value investing with individual stocks: Use value investing strategies to find underpriced securities and hold on to them.
- Invest in diverse asset classes: Consider adding real estate, commodities, currencies, and other assets to your portfolio.
- Start a business: Control your returns by starting a business or a side gig.
All of these ideas come with their own risks and potential losses. However, with them, you have the chance to overcome losses and offset the inflation risk that comes with keeping your money in a savings account.
No matter where you put your money, there’s a chance that your investment will lose value. The key is creating a portfolio of different assets that can withstand market events and overcome inflation risk in the long run.
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