Is Your Savings Rate Beating Inflation?
How Does Your Savings Rate Compare to Inflation?
Most people keep their money in a bank because it is perceived to be the safest place for it to be. The truth is, banks are so heavily regulated that they are right. In light of the financial crises of the past like Finsac and the 2008 Global Recession, the regulations that banks and other deposit-taking financial institutions have to abide by (particularly the 2014 Banking Services Act), serve as a safeguard for consumers so that their money is protected. Banks in Jamaica also offer deposit insurance which provide consumers with the protection that they can claim up to $600,000 per depositor, per financial institution in the unlikely event that a bank fails.
Banks are also required to place cash in a reserve with the Bank of Jamaica, so that they have some level of safeguard in case of a bank’s insolvency. This is usually a percentage of the bank’s prescribed liabilities (which includes money it owes to people that deposit money with them).
If you read my previous post/thread, you would have seen where I explained that interest rates have been declining. When it declines for loans, it also declines for savings. With that said, I’m sure you see that the returns you get on your savings account often require a magnifying glass to be able to discern. The highest interest rate I could find on a regular savings account was 2.5% and that was for amounts over $10,000,000. Someone with $25,000 in their account can expect to earn as ‘high’ as 0.1%. With compound interest that’s
= $25,000 x (1.001)^(no of months that money stays at the bank/12)
If you kept that in the account for a month it would be equivalent to $2 in interest.
Think about this in comparison to Jamaica’s inflation rate which the BOJ projects to average about 4.3% over the next eight quarters and was an average of 3.6% over the past 4 years. Keeping your money in a savings account for a long time will not help you to earn more than the relative value that money can give you over that same time period, but again I want to emphasize that if you are risk-averse (you are someone that does not like to take risks with your money) then a bank is the safest place for your money to be.
The alternative is to invest in a riskier option like an equity fund or the stock market and persons who have amassed larger savings often invest in appreciating assets like real estate. (A car is not an appreciating asset so never invest in one if you want to see returns on your investment; an appreciating asset increases in value over time). Again, Banks/building societies/credit unions are the safest option to keep your funds, I am making that explicitly clear. It is even safer than under your mattress, I promise you.
By placing your money in a riskier option, you have to be conscious of the fact that the value of the asset (e.g. stock) that you are investing in can go DOWN as well as up. Doing research and investing wisely is often hard, but necessary if you want to minimize the risk of placing your money with any institution other than a bank. The government has been encouraging Jamaicans to invest in the stock market in an initiative aimed at the ‘socialization’ of wealth, which I encourage, but you must be patient and you must understand that it is a risk, so do your investigation to ensure that you are investing in a sound company.
You should plan to hold stocks to meet your long-term financial goals (like buying a house, sending your children to university or saving for retirement) and you will not likely build wealth from keeping a stock overnight. The stock market, over-time, does beat the rate of inflation, particularly if you do something called ‘diversifying your portfolio’. To diversity your portfolio means that you invest in a variety of different financial instruments (stocks, bonds etc.) so that you minimize the chances of being hit all at once if a the value of one declines.
So a good way to strike a balance keep a portion of your money in safer options like a bank and place a certain amount in a riskier option like the stock market, if you have extra disposable income. What this amount is depends on your level of risk tolerance i.e. how much you could stand to lose without being financially hurt. I don’t know if you remember the Olint crisis, but among the people most hurt were those that took money out of an appreciating asset (the equity in their house) to invest in a riskier asset like the foreign exchange trading market.
I used a spreadsheet (my favorite thing to do) to compare the performance of $50,000 left in 4 different savings investments over 30 years using compound interest:
- A regular savings account earning 0.1%
- An investment account earning the avg. rate of inflation which is 4% (this would show what $50,000 today would be worth in 30 years.
- An equity account that combines the performance of a portfolio of stocks (the good will then balance out the bad).
- Investing just in one stock of an extremely high performing company.
Download the sheet here: Savings Option Calculator
The balance after 30 years for each speaks for themselves:
- Savings Account $51,522
- Investment Earning Inflation: $162,170
- Equity Portfolio $3.3 Million
- Stock $131 Million
I also decided to look at what would happen if you add $5,000 at the beginning of each year. Here are the results:
If you keep adding $5,000 to your investment, the balance after 30 years for each would be:
- Savings Account $203,717
- Investment Earning Inflation: $442,595
- Equity Portfolio $5.48 Million
- Stock $174.6 Million
If you read my article on why your mortgage interest rates matters, the same is true for your savings interest rate because of how compound interest works and its effect in growing your money. I hope these number spark you to take action, especially if you are planning for the future. Speaking of the future, look out for my next article on why Pensions matter!
Disclaimer: I am not a financial advisor, so ensure that you speak with one to get a better understanding of investing if you choose to do so.
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