How your savings account is costing you 10% per year
You're probably thinking “Costing me 10%?! My high yield savings account is making me 1%!”
Think again. If you are only saving, not investing, then YES, your savings account IS costing you ~10% per year.
Historically, the stock market has returned an average of 10% annually. So you may assume that the 10% you're missing out on refers entirely to investment earnings. However, that doesn't accurately portray what's really going on. In fact, there are two factors at play that, combined, are costing you 10%: Inflation and Opportunity Cost.
Explained briefly in my Cash & Inflation video, inflation is the increase in prices over time. I call it “cash’s kryptonite” because it deteriorates the value of every dollar. In other words, it eats away at your money’s purchasing power as the years go by.
On average, prices increase about 3% per year in the US. So if all you're doing is saving your money, each dollar you save is losing ~3% of its value to inflation on a yearly basis.
Here's a simple illustration to drive home this concept:
Let’s say you've saved $1,000. Great work! Assuming inflation drives prices up 3%, your $1,000 would be worth 3% less a year from now. Would your account balance actually go down? NO. I want to make that point very clear. But your $1,000 would only be able to buy $970 worth of stuff (in today’s money).
- After 1 year: $970
- After 5 years: $859
- After 10 years: $737
- After 20 years: $544
- After 40 years: $296
That means that if you're 25 years old and planning to retire at 65, each dollar you're saving today will only be worth about 30 cents when you reach retirement. Imagine that!
Okay, so there's 3% of the 10% that you're “losing” by only saving your money. Where does the other 7% come from?
This is the factor that, unfortunately, few people consider. The official definition of opportunity cost is “The cost of an alternative that must be forgone in order to pursue a certain action.” (Thanks, Investopedia.) In more layman’s terms, it’s the value you give up by going with one choice over another.
If you decide to save your money instead of invest it, you're giving up the investment earnings you could be making off of that money. As mentioned earlier, the stock market has returned ~10% per year on average. BUT, that doesn't account for 3% inflation. So the "real" return (adjusted for inflation) is closer to 7%:
10% total return - 3% inflation = 7% adjusted return
By choosing not to invest your money, you're essentially giving up, or “missing out”, on that 7%. Add that to the 3% you're losing to inflation, and BAM, your savings account is costing you 10% per year.
Here's how that looks in simple graph form using the same $1,000 starting cash balance from before:
If you don't invest your money, inflation will erode the value of your $1,000 down to $970 (grey line). If you do invest your money and it earns 7%, the value of your $1,000 will increase to $1,070 (gold line). The difference between the two outcomes is $100:
$1,070 - $970 = $100
And $100 is how much of your original starting balance? That's right! 10%!
$100 / $1,000 = 10%
Investing is the only way to outpace inflation over the long term. Putting your cash to work will ensure that the money you're making today will be able to afford what you need to buy tomorrow.
I'm currently typing this article on a MacBook, so let's use a laptop as an example of something you may want to buy now and in the future.
An entry level MacBook costs about $1,000 today. If you have $1,000 right now, you could afford it. However, if inflation continues to drive prices up at an average of 3% per year, that same laptop may cost $3,262 forty years from now. If you let your $1,000 just sit in your savings account, it would still be worth just $1,000 in forty years, and you wouldn't be able to afford the MacBook anymore. That's what I mean when I say that inflation diminishes the purchasing power of your money; it actually reduces how much you can purchase.
But what if you invested that $1,000 instead? Assuming it earns an inflation-adjusted average of 7% per year, it'd be worth $14,974 in forty years! Thanks, compound interest! In this scenario, you'll more than be able to afford that same MacBook in the future, even though its price would have increased from $1,000 to $3,262.
Again, investing is your only chance at outpacing inflation in the long run. That's why it's so, so important that you not only start investing early, but also understand how to do it. Blindly choosing funds in your retirement plan, or haphazardly picking individual stocks in your brokerage account likely won't get you a 7% average return. You've got to know which funds to invest in, and why and when to invest in them. That's why I focus on teaching you those concepts in the ReisUP curriculum!
There's no reason to “lose” 10% per year when the information you need to generate a positive return is at your fingertips. ReisUP against inflation. ReisUP for your financial future.