‘Save money for a rainy day.’ How many times have you heard that phrase? From parents to teachers to all sorts of role models, we get this piece of money management advice. The problem with this advice is that it isn’t entirely right. That’s right, putting your money in the bank is a bad move for many people. How come? One word: inflation.
Think of inflation as the process where your money rots slowly. As the years go by, your money rots slowly since it can buy less and less stuff. In fact, if you track inflation over a long enough period of time, your money would be worth pennies on the dollar. Shocking, right? It shouldn’t be. It’s all about the basic economic law of supply and demand. Whenever there is a huge supply of something and demand remains the same, its price usually goes down. This rule applies to widgets, computers, food, and-you got it-money.
With each passing year, the government prints up more and more money. Since money is no longer backed up by gold, the only limits to the amount of money a government can choose to print in any year are political limits. Consequently, as governments continue to flood the market with money, the price of your money continues to fall year after year. It takes more and more greenbacks to buy the same stuff it used to buy in the past. Prices keep rising. The rate of price increase on a year to year basis is called the inflation rate.
Do not let your money rot in the bank
If you put 100 dollars in the bank, and the annual rate of inflation is 10% and the bank pays you 1% interest, your money is worth essentially 91 dollars after a year. In other words, you lost $9 in value. The bad news is that it will continue to sink if you keep your money in the bank even if the bank pays you interest.
Your goal, if you want to preserve the value of your money, is to grow your money so that it keeps pace with inflation. If the annual inflation rate is 10%, you need to get your money to grow 10% so you don’t lose any value. The good news is that you can park your money in certain investments that have a rate of return higher than inflation.
Many stock funds appreciate in value at a rate higher than inflation. Certain types of government bonds pay interest rates that factor in inflation. Regardless of what you do, make sure the investment yields a rate of return higher than inflation.
Watch the tax
Make sure the investment you select appreciates at a high enough rate so that you still come out ahead after you factor in inflation and taxes. Too many investors don’t factor in taxes, and they end up barely breaking even on their investments. Also, keep in mind that some investments are not as liquid as others. A liquid investment means that you can easily cash out without having to wait a long time. Stocks are liquid. Real estate and art are not.