Say No To Banks
Photo by Andre Taissin on Unsplash
Today we will talk about storing your money in a bank account. You are probably already using multiple bank accounts on a daily basis whether it is for simply paying for your groceries, preserving for an emergency fund, or saving for a downpayment. Regardless of your situation, the one thing you should know is to never put all your money in a bank account. That would be a guaranteed way to lose money and I will explain why in this post.
Inflation Eats Your Money
The biggest reason why putting money in a bank account will result in lost money is due to inflation. What exactly is inflation? The definition of inflation is a general increase in prices and fall in the purchasing value of money over time. It means that over time your money is worth less as far as buying power. A great example of that is the cost of a gallon of milk in 1950 compared to the cost of milk today. Back in 1950 you would pay 83¢ per gallon of milk while today in 2021 on average you are paying $3.60 per gallon of that same milk. The purchasing value of your money decreased significantly from 1950 to 2021.
Saving money in a bank account was not always a bad place to save your money. In the 1980s things were very different and it worked for many people of that generation to use bank accounts as their main financial tools. Let’s consider a CD or a Certificate of Deposit. It means that you deposit your money and you are not able to touch it for a certain number of years. As a result, you earn a guaranteed rate of return. In 1980 the average yield on a five year CD, where you deposit your money for five years and you cannot touch that money, was 11.33% per year. Today, in 2021, the average return on a five year Certificate of Deposit is 0.96%. In the 1980s the average rate of inflation was somewhere around 3.5% and since 2000 the average rate of inflation has been 2.2%.
Math time, let’s translate the returns and inflation rates for both decades in dollars to get a much closer to reality example. If you had $100,000 by the end of 1983 then in 1988, due to inflation, that $100,000 would have the equivalent buying power of $118,000. Now if you took that same $100,000 and invested it in a five year CD at the end of 1983 then those $100,000 would have been worth $176,000 five years later. So thanks to that five year CD you made $76,000 and you out-paced inflation by $58,000. That is why putting your money in a bank account back in the 1980s was a good idea.
Let’s now see why it will not work for the current generation. Based on the 2.2% average rate of inflation since 2000, $100,000 in 2016 has the equivalent buying power of roughly $111,000 in the year 2021. If you invest in one of those CDs with a 0.96% return, $100,000 in 2016 will become $105,000 in 2021. Inflation out-paced you by $6,000. What if you didn't even put your money in a CD as most people do not do that. What most people do is they leave their money in a checking or a savings account. The average return on a checking account is 0.05%. So $100,000 in 2016 at 0.05% per year would be $100,250 by 2021. While it appears that you made $250, you actually lost $10,750 because inflation way out-paced you.
A Way to Beat Inflation
Photo by Mathieu Stern on Unsplash
There is good news! There is a way to out-pace inflation and you can avoid losing the buying power of your money. The answer is simple and it is to invest your money. If you are unsure where to start I recommend you to check the “Stocks for Beginners” post that will do a nice intro in what I am talking about. I am a huge fan of keeping everything super simple and it is not an exception when it comes to investing money. The easiest by far method of investing your money is to invest in the S&P 500 which is a good way to track the average returns of the stock market. The best part is that you can invest directly in a fund that tracks the S&P 500. Before you say that the stock market is a losing game and everyone loses money in the stock market, I want you to take a look at the historical data from 1930 until 2020. The S&P 500 Index had a positive year 78% of the time. There were also short term corrections where you are down on your money but it generally means you don’t sell in those years and you hold on, and you continue investing.
The best investing strategy is when you are investing using the dollar cost averaging approach. It means that you deposit the same amount every single month into a fund that tracks the S&P 500 regardless of the market situation. At that point, you are buying shares at a high price, buying them at a low price, and buying them in the middle. In return this allows you to lower the average price paid per share. Since 1930, the S&P 500 has returned on average 9.8% a year and if you want to out-pace inflation, the way is to invest. In contrast, keeping your money in the bank in a checking account, in a savings account, or in a CD is a guaranteed way to lose your money. You need to make sure you are doing something to out-pace inflation and there is nothing easier than to do this by investing in a passive index fund.
I want to wrap up this post by providing the last example, this time we will look at the S&P 500 return since 2000. As it was said earlier, inflation has averaged 2.2% per year since 2000. Let’s take a look at the performance of the S&P 500 Index. On January 1st, 2000, the S&P 500 was at $1,425.59 and on January 1st, 2020, exactly 20 years later, the S&P 500 was at $3,278.20. It shows that over those 20 years we saw a 129.95% return on the Index. And if you had invested $100,000 into a fund tracking the S&P 500 Index in 2000 you would have $394,901.43 as of the beginning of 2020. As you can see you out-paced inflation by a huge margin.
Wherever you are in your journey to financial freedom, remember, putting your money in a bank account is a guaranteed way to lose money and you would be a much better off investing them in a passive index fund.
