Soon after we start receiving money, we’re taught to save, but are we stalling financial growth by doing so? You could be doing yourself a disservice by doing the ‘smart thing’ and locking your money in a savings account. How could that be? Let me explain below.
If you aren’t familiar with the silent killer that is inflation, here is a quick definition by Investopedia. “Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time”. Essentially, inflation causes our dollars to lose their purchasing power over time. According to Trading Economics, inflation in Australia has risen by an average of 4.97% each year from 1951-2019. In recent times, inflation has slowed in Australia to around 2-2.5% each year on average from 2000-2019.
Figure 1: Inflation over the years in Australia.
How Inflation Is Hurting Your Savings.
Let’s employ a real world example of inflation to give context to the situation. Think back to your elders telling you that a can of Coke once cost $0.20, but now a can cost over $2. That is inflation in action. The can and its contents are still the same, however as inflation creeps up and compounds over time, that product you could once buy for a dime now costs you a dollar as the cost of living slowly rises and rises. So how does inflation impact you and me?
After doing a quick Google search on high interest savings accounts, you’ll quickly learn that best deals out there are offering between 1.9-2.8% bonus interests per year at the time of writing. Your rate will be available on your banking institutions website. Again, a simple Google search will get you to where you need to go.
For example, let’s say your savings account interest rate was 2% and you had $100 locked away. If you left that $100 in that account for 12 months, you would have $102. Sounds great, right? $2 for doing absolutely nothing. Wrong. This is where silent killer inflation comes into the fold. If inflation is at 2% per year, your 2% interest rate is swallowed up by inflation meaning you only break-even. At 2% inflation per year, what we could buy for $100 one year ago would now cost $102 after accounting for inflation!
So now that we know storing all of your cash in a savings account can erode your balances, let’s discuss alternate options to invest your money.
1. Convert Your Savings Into Real Estate
Real Estate investing can act as a fantastic shield against inflation. Over time, depending on what part of Australia you live in, you’ll notice that property prices have steadily risen over the past 50+ years. In fact, from 1993-2018 property delivered an average annual growth rate of 6.8% and 5.9% for houses and units respectively according to CoreLogic.
Now, of course, there have been various fluctuations in values property along the way. The recent declines we’ve seen in the Sydney and Melbourne markets are a great example. However, over the long term property values have increased more in less in-line or greater than the rate of inflation in Australia.
A bonus with owning Real Estate is that you could potentially enjoy rising rental income during an inflationary environment. Being able to steadily increase your cash flow hedges you against inflation.
So what if you’re not a fan of large mortgages or can’t yet afford a deposit? Investing in publicly traded real estate investment trusts (REITs) could also be an option to get into property. A REIT owns, and usually operates, income-producing real estate. REITs can provide exposure to the real estate market without going through the process of purchasing a physical investment property.
2. Save To Grow A Stock Portfolio
Investing in the stock market can protect against inflation through capital growth and payment of dividends.
In terms of capital growth, the stock market has proven to steadily provide higher returns over the long term. Market Index suggests that over the past 118 years (1900-2018) the All Ordinaries Index has achieved a 13.1% average annual compounded rate of return. The All Ordinaries tracks the average returns of Australia’s largest 500 Companies. Over in the U.S. Investopedia say the S&P 500 Index has achieved a similar return of roughly 10% per annum from 1926 – 2018.
Picking an individual company to invest in doesn’t always work out favorably if the proper analysis isn’t completed. Broad diversification across the whole market via index tracking exchange traded funds (ETF) is key to ensuring you achieve the average market returns without spending the time researching individual stocks.
Investing in the stock market can also protect you from inflation through dividend payments. As larger companies grow their profits, it’s common for them to employ surplus cash to reward their shareholders with dividends.
For more information on how to start investing in the stock market, check out our Simple Guide On How to Make Your First Stock Investment in Australia.
Now obviously we do all need some cash stored away for a rainy day. In saying that, it’s certainly worth exploring any one of the strategies above to ensure your dollars aren’t being eroded by inflation. Being aware of inflation and making plans to protect against it is fundamental to growing wealth.
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Disclaimer: This website (the “The Money Pal”) is published and provided for informational and entertainment purposes only. The information in the Blog constitutes the Content Creator’s own opinions and it should not be regarded as financial advice.