A couple of years ago, a local restaurant in my town had an ice cream cone giveaway. The promotion was heavily advertised, including in the newspaper and on the local radio station.
When the day of the deal arrived, I drove past the establishment to see how many people had shown up. The line was quite long, out the door and around the building. I figured that if I got in line, I would have to wait about two hours for my free ice cream cone.
For an ice cream cone that normally cost about $1.50.
When I thought about the time I would have spent standing in line for an ice cream cone, I realized that, rather than saving money, I would be wasting it. Standing in line for two hours for $1.50? That's not saving money at all -- especially when I figure that an hour of my time is worth about $85. I'll just come back another day, spend 10 minutes, and pay the $1.50.
Sadly, this mentality -- one that figures that standing in line for two hours for a free ice cream cone is a good deal -- is a common one. And it's a mentality that even applies to savings accounts. You might think that you're saving money and building wealth when you keep your money in a savings account, but the reality is that you're losing money. Here's why.
Inflation And The Erosion Of Your Purchasing Power
The reason that savings accounts result in real losses is due to the way inflation erodes your purchasing power.
Over time, prices rise...that's inflation. Inflation can also be described as a decrease in purchasing power. Either way, inflation boils down to the fact that your dollar doesn't buy as much as it used to.
You've probably seen this principle in action in your own life. I remember when I could buy a can of soda from a vending machine for 75 cents. Now I pay more than a dollar if I decide to get a soda from the machine. Inflation also shows up in smaller packaging. Remember when a quart of ice cream was a true quart? Now it's a little bit less than a quart -- but you still pay the same amount of money (or even a little more).
Inflation affects all of us, from the cost of food to the cost of gasoline to the cost of other goods and services. The federal government tracks inflation rates over time so that we have an idea of where prices are headed. In fact, you can find historical inflation rate data dating to 1914 -- that's almost 100 years.
Once you understand that inflation is there, quietly undermining your purchasing power, you realize that all of your investment returns, in 'real' terms, are actually lower than you thought. And, even though you probably don't think of a savings account as an investment, the truth is that the returns from your savings account are also eroded by inflation.
Negative Real Returns From Your Savings Account
According to the Consumer Price Index calculation used to measure overall inflation in the U.S. economy, the average inflation rate for 2012 was 2.07%. Consider that for a moment, and then look at the return you are getting from your so-called high-yield savings account. Chances are that you are lucky if you are earning 1%.
If your money lost value at a rate of 2.07% last year, and your savings account only returned 1%, the reality is that your real return is actually minus 1.07%. That's a negative return, meaning that you are losing money. And that doesn't even include taxes on your interest income. By the time you pay those, your losses are even greater.
In some environments, a high-yield savings account can provide you with capital preservation while still offering positive returns. For instance, in 2006, I opened a high-yield account that offered 5%. In 2006, the average inflation rate was 3.24%. However, after 2008, rates dropped dramatically. The only year since then in which interest rates on savings accounts have beaten inflation was 2009, when deflation was in effect.
The conditions for earning more than inflation on a savings account don't exist right now.
Even if your deposits are insured, your buying power isn't. Your savings account can make a decent emergency fund, but if you expect to build wealth over time, a savings account might not do the trick -- at least not until rates rise. But then you have to hope that inflation doesn't rise at the same rate or faster.
The Investing Answer: In terms of real returns, you're losing out with a savings account. Instead, look for inflation-beating investments to offset your low-yield losses. Certain exchange-traded funds (ETFs), stocks, and other assets can help you earn a higher return that outweighs the eroding power of inflation.