Having a safety net of savings – or an emergency fund – is a smart financial move, but that does not necessarily mean that you should hoard all your cash in your savings account. When you have a buffer in place, at a reasonable size, it is time to start investing.
What is a reasonable size buffer you might ask? That’s a great question, but unfortunately, there’s no straightforward answer. The annoying fact is that the answer is, ‘It depends’.
Contemplate all possible scenarios that might require a bit of cash quickly in your life. It can be anything from losing your job (and that means calculating how long it might take until you can secure an income again), to your car breaking down, your pet getting ill, or your washing machine breaking down on you. This is what you need a buffer for. For someone it might mean the equivalent of one month’s salary, for others it might mean six. It all depends on your income and expenses, but also on how much you can tweak your expenses if needed.
But once you have this buffer in place, it is time to ditch the savings account. The reason behind this is the fact that most savings accounts offer little to no interest. In normal times this is a problem, but with todays soaring inflation, it’s an even bigger one. Despite the surging interest rates (a tool to beat this increasing inflation) banks are slow at increasing the interest rates on savings accounts.
What is Inflation? A Big Mac Example
Inflation is the slow devaluation of a currency over time. Or, another common definition is that it’s the “slow increase of prices over time.” If you’ve ever felt like things just keep getting more expensive over time, that’s because they are. Let’s use the Big Mac Index as an example.
When McDonald’s first introduced Big Mac to the public it cost just 45 cents. Today, that same exact product will cost you around 5 USD. This is a price increase of more than 1000%. If you think about it long enough, it really doesn’t make any sense for McDonald’s to increase the price of a Big Mac at all, and especially not by 1000%.
Since the 1960s, McDonald’s has gotten exponentially more efficient. Today, it has more sophisticated methods for farming, transporting, fertilizing, communicating, and antibiotics to keep cows healthy. With all this advancement, McDonald’s should be able to produce more burgers at a lower cost to keep prices down. So why in the world is the average cost of a burger increasing?
The answer is inflation.
The Big Mac isn’t increasing in price. Your money is decreasing in value.
The rate of inflation depends on a handful of different factors. Usually, it’s around a manageable level of 2-3% per year. This is also the rate at which most global central banks want inflation to hover. However, the inflation rate today is 10% in the Eurozone, and 6.9% in Canada. In other words, your money is losing 10% of its value in Europe, and 6.9% in Canada each year. This means that if you saved EUR 10,000 ($10,000) last year, it’s only worth about EUR 9,000 ($9,310) today in terms of purchasing power. If this continues at the same rate, it will only be worth EUR 8,100 ($8,667.61) next year.
This brings us back to saving money.
Inflation + Low Interest Savings Account = Dangerous Cocktail
If you keep your money in a savings account, you are actually losing money each year in terms of purchasing power.
Your savings are basically earning close to 0% in interest. Meanwhile, inflation is driving the prices of everyday goods up by almost 10% (or 6.9%) each year at today’s rate. Therefore, you should not keep all your money in a savings account. Instead, you should invest your money in a place where it can grow, like the stock market. Ideally, it needs to grow at a rate higher than inflation.
But hold on a minute, global stock markets are down this year too – right?
The stock markets across the globe have indeed had a tough 2022, but if we look at the markets historically it all adds up. Morningstar’s Global Index has had an annual return of 8.2% in euro during the past 20 years, while Morningstar’s European Index shows an annual return of 6.5% during the same period.. The Morningstar Canada Index has had an annualized return of 8.8% for the past 10-years, the timeline for which we have the data.
That is well above the inflation target of 2%.
This does not mean the road will be straightforward, there will be bumps along the way, but in the long run it can help you beat the inflation monster.
