When I was a kid, I thought that in order to become wealthy, you had to save a lot of money.
If you kept saving and saving, soon you would have a lot of money, right? It seems to be the safest and most reliable method to generate wealth, does it not? Unfortunately, this isn’t quite the case. Well, it certainly isn’t true for people on a regular salary like myself.
Why you can’t save your money forever
The short answer to why only saving won’t make you rich is inflation. Do you remember how everything used to be so much cheaper back in the day? Like, your grandparents bought an entire home with the cost of your annual salary? This is a normal process known as inflation. Or, it could be the insane Melbourne property market but bear with me.
To keep things simple, inflation means that money loses its value over time. $1 in 1970 is not the same in $1 in 2021. In fact, $1 in 1970 had the same purchasing power as $11.88 – over ten times the value! The RBA has a great inflation calculator that you can play around with it, check it out here:
Keeping this in mind, if you saved $100,000 in 1970, it would have the same purchasing power as $1,187,723. Therefore in order to preserve your wealth from 1970, your savings would have had to increase with inflation or you would be “losing” over a million dollars.
The same can be said about your wealth today, sitting in a savings account. If you have an interest rate less than the inflation rate, then you are losing money and purchasing power every single day. As of May 2021, most banks in Australia do not offer interest rates on savings accounts that even match inflation, forget about even beating it.
How to actually preserve wealth
After reading all that, you may be thinking – how do I actually keep my money and not let time erode it away? It’s pretty straightforward – you need to make sure your money is beating inflation.
What does that mean? Well, in simple terms your money should be increasing with the inflation rate. If inflation is at 2%, then your cash should be increasing by 2% every year. This doesn’t mean that you add 2%, rather it does this on it’s own. One of the easiest ways to do this is by moving your funds to a savings account that offers a 2% or higher rate.
However, with current low interest rates it can be hard to find such an account. Not to worry, you can also beat inflation by investing your money. This could include buying real estate, stocks or even precious metals. It’s all about doing what works for you. For myself, I prefer investing in stocks. With an average return of 8 – 10% per year, my wealth grows at a much faster rate than inflation. This means that not only will I be able to preserve my wealth over decades, but also grow it. Savings rates at bank accounts are so low that I prefer only having my emergency fund in cash with the rest of it going straight into investments.
Want to get started with investing but unsure how? Check out some of my articles around this topic:
The other side on the coin
Now, if you’re a saver and prefer that – it’s not all bad! In fact, saving can be the better option in many cases! Here are some situations in which saving might be the “correct” choice.
Emergency funds. Do not invest your emergency fund! I’ve spoken a lot of emergency funds, and chances are that you will have 3 – 6 months of your expenses stashed away. If you don’t, be sure to read my article on it. No matter how large your emergency fund is, you need it in cash as it should be easily accessible – don’t worry about inflation!
Timing. Similar to an emergency fund, a key situation is if you need your savings within a short period of time, let’s say in two years. Perhaps for a house deposit or international travel. Two years of inflation is not going to be substantial enough and will be well worth the liquidity that is needed. Furthermore, if you will be using your savings for something like buying a first home, you are already protecting that wealth from eroding over time.
Risk tolerance. If you can’t watch the dollar amounts that you have saved decrease without having a heart attack, then investing simply isn’t for you. A big advantage of keeping your money in savings is that the dollar amount will not decrease, while you risk that with investing. However, I would advocate for better financial education and research if you feel this way.
Greater control. If you save $100 a month, you know for certain you will have $1,200 a month at the end of the year. It doesn’t quite work like that with investing. If you invested $100 a month, on average you’ll have around $1,353 at the end of the year but this is not a guarantee – at all. You could be left with $900 or even $1,600, it all depends on what the market at the time and what you invested in. It can be harder to reach financial goals when you aren’t 100% sure how much money you will have after a certain period of time.
That’s it! I hope this has given you a great understanding into inflation as well as ways to overcome it and situations when it is okay to take the hit. Saving money is a great first step to achieve your financial goals so if you have enough money laying around where you actually have to think about inflation, congratulations! It means you’ve done well. Thinking about inflation and investing can be intimidating especially if you’re new to personal finance. However, some research and education can give you an excellent foundational understanding that will support you throughout your life. If you have any questions feel free to contact me here.