Over the past weekend I was driving and listening to a personal finance program on the radio. A man in his early 30’s called in and said that he has about $150,000 (which is everything he has) sitting in a bank account. He is currently earning 0.60% on his money and wanted to know of a way to earn a higher return without investing in the stock market. He is risk adverse (afraid to take on risk with his money) and doesn’t want to lose anything. The host said that this person was part of the younger generation that is scared of investing in the stock market because they lost everything in the market collapse of 2008. Because of this, they will need time until they feel comfortable investing in the market again.
I felt bad for this caller and others in his shoes. The reason is because while they refuse to invest in the stock market for fear of losing money, the safe place where they have their money, saving accounts, are losing them money as well, through inflation.
With interest rates low, inflation easily erodes away your buying power. Many do not realize this however because when they look at their bank statement, it still shows the same principal amount each month.
How Inflation Works
In simple terms, inflation makes goods and services more expensive to consumers. If the inflation rate is 3%, that means prices are increasing at roughly 3% per year. So a pack of gum that costs $1.00 today will cost $1.03 next year. The higher the inflation rate, the faster prices increase.
How You Are Losing Money
If you are only earning 0.60% on your investment, in one year, $100 will be worth $100.60. With inflation currently around 2.5%, in one year anything that costs $100 today will cost $102.50. By playing it safe, you “lost” $1.90 in purchasing power.
If on the other hand, you invested in a bond fund that earned 3%, you would have earned $3.00 in one year. So a $100 investment would be worth $103. Take away the cost of inflation from above and you are left with $0.50. After inflation, you still had a positive return.
You Need To Invest in The Market
What scares me most are that the majority of people that are afraid of the market will not have enough to retire. As they save as much as they can, inflation is going to eat away at most, if not all of their earnings. The solution: invest in the market. I am not saying you have to have everything in the market because you don’t. You can still keep a healthy bit of money in cash. But you need to take some risk with your money.
Let’s assume you refuse to take no risk with your money. Without risk, you will earn virtually no return as any return you do earn will be eaten away by inflation. We will assume you retire at 70 and live until 90. We will also assume you will live on $50,000 per year and that Social Security will cover $18,000 per year. This means you need to save $640,000 by the time you are 70. Without Social Security, you are looking at needing to save $1,000,000.
If you are 30 years old, to save $640,000 means you need to save $16,000 per year, assuming you have nothing saved currently. If you earn 5% per year, that $16,000 per year drops to just over $5,000. That sounds more manageable.
The point that I am trying to make is that by not taking risks with your money, you are in truth taking a very big risk: not being able to afford to retire. If you are someone who fears investing in the stock market, I urge you to read up on the subject and to educate yourself on it. Put some money into relatively safe investments so you can earn a higher return and have a better chance at being able to afford retirement.