Monday, September 24, 2012

The Savings Plateau

I figured it would be a great way to start the week with a nice math exercise.  Awhile back, I had to take part in a new home owner's workshop.  The reason for my attendance was because I was part of a first time home buying program through my bank and the state.  In order to fulfill my side of the agreement, I had to attend an all-day first time home-buyer workshop which focused on the financial and upkeep sides of owning a home.  Topics such as paying for your mortgage, knowing when to fix up a problem, and developing budgets were all discussed.  As you can imagine, this stuff was all pretty boring to me.

One aspect of the whole program bothered me though; the idea of savings accounts.  The instructor insisted that savings accounts were the best way to save up for large purchases.  Being a dutiful P-Money, I raised my hand and pointed out that most savings accounts are earning around 0.25% interest per year.  Assuming the inflation rate is about 3%, you actually lose approximately 2.75% of your money's per year by keeping it in a savings account.  The instructor promptly laughed at me, looked around at the other folks in attendance and said, "I don't know about you all, but to me, a dollar saved is a dollar earned".  As you can imagine, I was a little miffed, and was frustrated that this type of information was being taught.

Let's look at this concept another way with the scenario of someone who puts $100 a month away in a savings account.  They are probably sitting back and thinking that they are in fact doing a really good job, being responsible, and saving for a big purchase or two.  Even worse, what if the person in this case uses the savings account as their preferred medium for retirement savings.  Will they earn enough for their future.  Unfortunately, with returns below the inflation rate, this money will eventually reach a value plateau in conjunction with the amount the save each month.  The below chart illustrates how your money will reach an eventual plateau.

Savings Plateau
The blue line represents the $100/month savings deposit.  The red line represents the maximum value of the portfolio.  Each month, an additional $100 is added and the previous balance is multiplied by 97.25% (the inflation rate of 3% minus the savings account interest).  As you can see, the impact of that $100/month savings slowly deteriorates until it is only making up for the loss due to inflation.  The most this portfolio will ever me worth is $3,636.  An easier way to calculate this is to take your initial balance and divide it by (1-net inflation rate).  Needless to say, my point is that savings accounts are pretty terrible for any sort of long term savings plan (greater than 1 year).  Even CD's are pretty paltry at this point.  Even though there is more added risk, your best bet to at least keep up with inflation is to invest this money in something like TIPS which I mentioned before.

Investing can be really frustrating especially when you think you are doing such a good job.  Don't fret too much, reevaluate your situation and find a better alternative.

Good Luck!

Wonderful Moment of the Day: September weather, cool, and sunny.

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