Saving & Investing: Where to Put One’s Savings (11th Blog Post)

Once you have started to save money, where do you actually put that money? You have options.

The easiest option is to stick your cash savings underneath your mattress so to speak. That said, this is not a great option because you would not earn any return on your money. In other words, you would not be able to grow your money doing this. Furthermore, if you choose this option, it is highly likely that the purchasing power of your savings would decrease because of an economic phenomenon called “inflation”.

Inflation is a general increase in the prices of goods and services in an economy. In the United States, inflation is typical. In other words, prices of goods and services in the United States tend, overall, to increase each year. What does that mean in practical terms for you and me as consumers and perhaps savers? It means that a dollar today is going to be worth more than a dollar a year from now, two years from now, three years from now, etc. In other words, $1.00 today will be able to buy you more than $1.00 in the future (assuming there is inflation, which there typically is). Why is that? The reason is because inflation, which occurs over time, eats away at the purchasing power of a dollar. Purchasing power is the amount of goods and services that a unit of currency, like the US dollar, can buy at any given time. As prices of goods and services rise, a fixed amount of money – like a single unit of currency or a fixed amount of savings -- can buy less. To help make these concepts of inflation and decreased purchasing power easier to understand, let’s provide an example.

	Amount of Your Savings	Cost to Buy a Given Basket of Goods & Services
Original Value	$1,000.00	$1,000.00
Growth Rate	0.0%	3.0%
New Value	$1,000.00	$1,030.00
Change in Dollars	+/- $0.00	+ $30.00

Difference: $30.00

Summary Explanation: In this example, the purchasing power of your savings declined by $30.00, as the same basket of goods & services that you wish to buy now costs $30.00 more (due to an inflation rate of 3.0%) than it originally did while the amount of savings you have remains unchanged. Said differently, whereas previously your savings could be used to purchase the entire basket of goods & services, your savings now will only cover 97%[1] of the price of that same basket.

[1] i.e., $1,000/$1,030

Over time, inflation erodes the purchasing power of one’s cash savings and will eviscerate it if one’s savings are not earning any return for a prolonged period.

A second option is to put your savings in a checking account at a bank. That said, this is not a great option either because, again, you would not earn a return on this money. As with stuffing cash under your mattress, it is highly likely that the purchasing power of your savings would decrease, if you choose this option, because of the impact of inflation.

A third option is to put your savings in a savings account at a bank. When you do this, you at least give yourself the opportunity to earn interest income because banks pay savings account holders interest on their savings account deposits. Savings accounts therefore are a better option than stuffing your cash savings under your mattress or putting them in a checking account. That said, if the annual interest rate that your bank is paying you on your savings account is less than the annual rate of inflation, then, again, the purchasing power of your savings would end up declining. To illustrate:

	Amount of Your Savings	Cost to Buy a Given Basket of Goods & Services
Original Value	$1,000.00	$1,000.00
Growth Rate	2.0%	3.0%
New Value	$1,020.00	$1,030.00
Change in Dollars	+ $20.00	+ $30.00

Difference: - $10.00

Summary Explanation: In this example, the purchasing power of your savings declined by $10.00, as the same basket of goods & services that you wish to buy now costs $30.00 more (due to an inflation rate of 3.0%) than it originally did while the amount of savings you have increased by only $20.00. Said differently, whereas previously your savings could be used to purchase the entire basket of goods & services, your savings now will only cover 99%[1] of the price of that same basket.

[1] i.e., $1,020/$1,030

A fourth option is to take your savings and invest it. When you do that, you give yourself the opportunity to grow your savings, to make your money work for you, to earn a return on your savings including a return that potentially can exceed the rate of inflation so that the purchasing power of your savings increases rather than decreases. Why would the purchasing power of your savings increase rather than decrease if you can earn a return on your savings that exceeds the rate of inflation? The reason is because you will grow your savings and that will give you more dollars to buy the same basket of goods and services. More dollars to purchase the same basket of goods and services whose overall price has risen less than the growth rate of your savings mean that you can buy more of those goods and services. To make this concept of increased purchasing power easier to understand, let’s again provide an example.

	Amount of Your Savings	Cost to Buy a Given Basket of Goods & Services
Original Value	$1,000.00	$1,000.00
Growth Rate	7.0%	3.0%
New Value	$1,070.00	$1,030.00
Change in Dollars	+ $70.00	+ $30.00

Difference: + $40.00

Summary Explanation: In this example, the purchasing power of your savings increased by $40.00. While the same basket of goods & services that you wish to buy now costs $30.00 more (due to an inflation rate of 3.0%) than it originally did, the amount of savings you have grew by more than $30.00. It grew $70.00. Said differently, whereas previously you would need to spend 100% of your savings to purchase the entire basket of goods & services, you now could purchase that same basket in full plus have $40.00 of savings left over.

We will discuss the topic of investing in further detail in our next blog post, although here we will throw out one additional critically important, and powerful, concept just to spark your interest in the option of investing. That is the power of compounding. Investing gives you the opportunity over the long-term to compound your money. What do we mean by “compounding” or “compound your money”? We mean earning a return on the returns you generate on your investment. When you invest, you give yourself an opportunity over the long-term to earn a return on the actual amount of money you invest. Through the power of compounding, though, you also give yourself an opportunity to earn a return on the returns you earn on the amount of money you invested. And, in doing so, the actual effect of compounding increases the longer you remain invested. Admittedly, this may be a bit confusing so let’s walk through an example to illustrate. In this example, you decide to take $1,000 of savings and invest it.

	Value of Your Investment at Beginning of Period	Investment Return	Value of Your Investment at End of Period	Annual Gain (+) / Loss (-)
Year 1	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 2	$1,060.00	6.0%	$1,123.60	+ $63.60
Year 3	$1,123.60	6.0%	$1,191.02	+ $67.42
Year 4	$1,191.02	6.0%	$1,262.48	+ $71.46
Year 5	$1,262.48	6.0%	$1,338.23	+ $75.75
Year 6	$1,338.23	6.0%	$1,418.52	+ $80.29
Year 7	$1,418.52	6.0%	$1,503.63	+ $85.11
Year 8	$1,503.63	6.0%	$1,593.85	+ $90.22
Year 9	$1,593.85	6.0%	$1,689.48	+ $95.63
Year 10	$1,689.48	6.0%	$1,790.85	+ $101.37

Summary Explanation: In this example, you will notice that over 10 years the value of your savings grew from $1,000.00 to approximately $1,791. That represents a 79% cumulative return on your initial investment.[1] You will also notice that the annual gains as measured in dollars that you generated on your investment increased each year even though the annual gains in percentage terms that you generated on your investment remained constant at 6.0%. This shows how the effect of compounding increases the longer you remain invested. As you can see, a given investment return – in this example, 6.0% -- on a larger amount of money is going to generate a larger gain as measured in dollars than that same investment return on a smaller amount of money. Of course, one will not receive the benefit of compounding if one decides to withdraw all of one’s gains each year (i.e., each year that one generates gains). To benefit from the power of compounding, one needs to reinvest at least a portion of one’s gains.

[1] ($1,790.85-$1,000.00)/$1,000.00

Given our summary explanation, you may wonder how the value of your savings at the end of 10 years would compare if you decided to withdraw all of your investment gains each year, rather than reinvest at least a portion of your gains and give yourself the opportunity to compound your money. Here is what it would look like:

	Value of Your Investment at Beginning of Period	Investment Return	Value of Your Investment at End of Period	Annual Gain (+) / Loss (-)
Year 1	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 2	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 3	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 4	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 5	$1,000.00	6.0%	​$1,060.00	+ $60.00
Year 6	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 7	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 8	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 9	$1,000.00	6.0%	$1,060.00	+ $60.00
Year 10	$1,000.00	6.0%	$1,060.00	+ $60.00

Summary Explanation: In this example, you will notice that over 10 years you generated a cumulative gain on your savings of $600[1]. That represents a 60% cumulative return on your initial investment.[2] Not bad for sure, although it is significantly lower than the 79% cumulative return in our example of the power of compounding. You will also notice that the value of your savings at the end of 10 years grew from $1,000.00 to only $1,060 because you did not give yourself the opportunity to compound your money. Finally, you will notice that the annual gains as measured in dollars that you generated on your investment were the same each year. They did not increase because you did not give yourself the opportunity to earn a return on the returns you earned throughout the 10-year period.

[1] A $60.00 gain each year x 10 years [2] ($1,600.00-$1,000.00)/$1,000.00

Regardless of whether you are able to or wish to take advantage of the power of compounding, when you invest your savings you give yourself the opportunity to make your money work for you. Financial experts tend to agree that investing is one of the best ways to grow your money over the long-term and achieve your financial goals. With that said, we should also make it abundantly clear that investing carries with it risks, including the risk of losing money. Furthermore, regardless of what assets you invest your money in, your investment returns will likely vary from period to period – including be negative -- because in practice the values of individual assets fluctuate rather than go straight up. This is why investing for the longer-term, rather than for the shorter-term, increases one’s probability of investment success. While there are no guarantees, investment experts generally agree that the longer one’s money remains invested the greater the probability that one will generate positive returns. Alternatively, when one invests with a shorter-term view, the timing of when exactly one makes such investments becomes a more critical determinant of the success or failure of those investments.

By the way, if you choose to put your savings in a savings account at a bank, you can also benefit from the power of compounding. After all, banks pay savings account holders interest on their savings account deposits and the savings account holder can earn interest on their interest income. While putting your savings in a saving account has less risk associated with it than investing your savings, it is worth exploring and understanding whether the return you can generate on your savings in a savings account will be competitive with the returns you potentially can generate by investing. It may not be.

A fifth option of where to put your savings is to use your savings to pay down or completely pay off any outstanding debt you may have. Any high interest rate debt, which typically includes, for example, credit cards and personal loans, may be especially attractive debt to pay off. When you borrow money, those who lend you the money typically will charge you interest on the loan. The higher the interest rate you are charged, the more interest expense you will owe. And the more interest expense you are shelling out, the less money you have to spend on other needs and priorities that you may have. So getting out of debt, especially high interest rate debt, can be an incredibly valuable use of one’s savings, one that is also financially liberating given that it results in greater financial freedom for those in debt.

Finally, you could use your savings to start your own business. Of course, starting one’s own business has its own risks and, while an exciting path to take for many, is definitely not for everyone.

I would love to hear from you. Any ideas, experiences, thoughts, comments and questions….please do share.

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