Naive Investor Chapter 3: Savings vs Interest

Investing with 'Other People's Money' is complicated and not the place to start accumulating wealth. Savings are.

Savings work because money has no expiration date. One of the functions of Money is as a store of wealth. Wealth = command of resources = purchasing power.

To put it simply, if you got paid in coupons, identical to cash in every way except that they expired by your next pay day, there would be no point to 'saving' your coupons. They expire.

Cash doesn't expire, so if you get paid $100 today, you have $100 of purchasing power today. You can save some of that $100 till next pay day. If you saved $50 per week, then your purchasing power on pay day next week would be $150, the week after $200, and the week after $250.

If you live within your means (and then some) you will be wealthy. By far the best return you can get on anything is to be paid for your time. Trading on your labor.

Thus there are good practical considerations like 'pay yourself first' which is putting your savings away at first opportunity into an account you can't readily access.

How wealthy can you get by saving? It depends...

First on your savins ratio, this is something you should know and many don't. Savings ratio is what amount of your pretax earnings you save per year (month, week etc.)

Apparantly 7% is good. I've always managed between 20-30% but admittedly I have little to no financial obligations. I'm also told via hearsay that the average US citizens savings ratio is (-3%).

With savings your purchasing power increases over time, therefore to some extent financially you become less and less vulnerable.

But in its basic form, your savings uninvested are passively invested in cash, and cash generally speaking is a terrible investment. (It's why companies pay you in cash over an ongoing ownership stake in the company).

Cash basically is a promisory note, it has no intresic worth and is rather like a coupon that gives you an entitlement to a piece of all the resources in the world (value added or not).

The thing is that more money is created but resources are finite. So your 'share' in the world resources gets diminished by a growth in the money supply.

Hence 'printing more money' doesn't work. Because it just reduces the value of the money already in circulation.

Think if you will, of a company that earns $100 per year. (a poor company I know). They have 10 shareholders, that 'Share' that $100 between them, or $10 each. If the company offers more shares (90 more) then your entitlement shrinks from $10 to $1. So too if the government prints more cash, or banks create more money, or store owners put up their prices.

The purchasing power of money erodes over time. This erosion in purchasing power is called inflation and gives way to the general principle that 'a dollar today is better than a dollar tomorrow'. A sentiment that runs contrary to the notion of saving.

The 'healthy' rate of inflation measured against a 'basket of goods' called the Consumer Price Index or 'CPI' is somewhere between 3-4% per annum. What this means is that after a year, your dollar from January 1st, will be worth about 97c in terms of the goods it purchases. The tricky thing is, your bank balance will still say '$1' thus many people don't realise that inflation is the enemy.

Thus if saving is about preserving and building your purchasing power, inflation is the only enemy to beat.

While you have an income, if you squirrell away $2000 a year, you don't have to worry so much about the $60-$80 lost purchasing power each year. When you don't have an income its worse, but also not forebodingly worse.

If you retired in 40 years time with $1 million in the bank you might think it a princely sum. The danger of inflation is that with 3-4% inflation compounding per year, that might cover 3 years living expenses.

"Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars' worth of groceries. Today a five-year old can do it." - Henny Youngman.

Inflation is what necessitates taking some risk and investing. A high interest online savings account at the moment gives you about 3% or so, which accounts for most of the lost purchasing power of inflation currently. But it is still losing purchasing power.

The general principle of investing, for the sole purpose of improving your financial position is beating inflation. If inflation is 1% you just need to beat 1%. If inflation is 14% you have the much more daunting task of beating 14%.
I would add at least a couple of percentage points onto whatever the official inflation rate is. The reason being that the CPI isn't what it used to be.

John Howard for example, instructed the ABS (or whoever) to remove credit card debt from the CPI, so that inflation wouldn't look so bad. The point being, a lot of subjectivity and interference has been applied to the CPI since its inception, no matter which country in the world. So better to be safe than sorry and add 1 or 2% to the official inflation figure and adopt that as your wealth preserving goal.

Some risky investments though, can result in you losing money on them over a period of time, meaning you have to suffer the loss and the effects of inflation.

Thus if you are particularly risk averse, just leave your savings in cash and suffer the effects of inflation.