Why Inflation Will Destroy Your Savings and 4 Simple Steps to Prevent It

You thought investing was the risky one, right? It's true, there's a certain amount of risk involved. But let me tell you about a guarantee-if you don't invest, even a little, you're going to lose money.

How? Inflation.

Let's take a quick example. My savings account offers .20% APY (annual percentage yield-which means "yearly interest"). It's not even a decent rate like 2.5%. I find this quite embarrassing. Here's why:

Assume that you have $10,000 in that savings account for 20 years. At 2.5% you'd have just under $16,500.

That's not bad, is it? You've made $6,500 on the deal. Good for you. But here's where it gets ugly. According to Stanford University's Hoover Institution and other sources, inflation in the 20^th century has averaged about 3%. In other words, every year a dollar was worth 3% less than it was the year before. And there's no reason to think something similar won't keep happening.

So? Let's run those numbers again. In 20 years at 2.5% interest and an average of 3% inflation, the buying power of your account at $10,000 would be about $9072.00. Because of inflation you would have essentially lost $928!

But if you're like me, you spent years in an account that pays .20% interest and didn't realize it. At that rate, the $10,000 would grow to $10,407.69 in 20 years. But with 3% inflation that would only be worth $5,762.49 in today's dollars (its "real" value).

You would have lost $4273.51.

Let me say that again. You would have lost nearly half your money! Another 5 years and you would have lost more than half.

Now I'm all about saving money. I think it's great if you're stashing some in the bank. But stash wisely. Here's four steps to do so.

Step 1 - find a better savings account.

Make sure it's one that pays better than average inflation. If, for example, you save that $10,000 in an account that pays 4.3% APY, you'll have $23,210.59 in 20 years. And that money will be worth about $12,851.14 in today's dollars. That's a $2,851.14 real gain. If you have less to put in the account, at least feel good that you're not losing money.

You can get that kind of savings (4.3%) right now at ING Direct. HSBC and Emigrant Direct are currently offering 5.05% APY for their online savings accounts. That will be worth $26,786.82 in 20 years and $14,831.21 in today's dollars. That's a $4,831.21 real gain!

Look around, ask for friends' experiences, read personal finance blogs. See what people are saying about these different companies. Compare rates.

Step 2 - stash money in a CD.

Obviously, if you have a small savings account, you won't have money for certificates of deposit (or the next step). Just keep putting money in the account until you're ready for this step and the next. Now that you've got better returns, you'll actually be earning something, not losing money. Good job. Keep reading, though, because everyone should do Step 4.

If you have money that you don't think you'll need for a while, great! Put it in a CD. I won't run the specifics this time, but let's just say that most CDs will get you better returns than savings accounts. And you can certainly find one if you look.

The only disadvantage is the early withdrawal fee. But that encourages me to keep my money in. And if it was an emergency, the fee wouldn't stop me from using my money.

Right now I have $1000 in a CD earning 5.25% annually. If I need to pull it out, it'll cost me $13.13, whether in the first month or the last one. Say that I need to pull it out in 6 months; I'll at least have another $13.13 in interest.

Shop around online and find a bank with a competitive offer and a good reputation. It'll make things smoother.

You don't have to use a CD. But if you don't have enough that you feel comfortable taking the next step then go the CD route. Stick it in a CD while you save up more, for instance, and earn some extra investing money.

Step 3 - invest in an index fund.

A good savings account will keep you from losing money. It may help you gain a little. A CD will help you earn a bit more. But let's now consider index funds.

Index funds aren't sexy. Investors tend to buy them and hold. That's because these funds follow the market, they don't try to beat it. That makes it easy for those of us who don't have the time or money to play on the stock market. (I say "the money" because buying and trading stocks will almost certainly earn you less money than investing in a good index fund.)

In his book The Lazy Person's Guide to Investing, columnist Paul B. Farrell explains the stakes (Warner Books : NY, NY, 2004). Stocks offer us the chance to greatly increase our wealth. Yet, there's an information overload. We don't know when it's best to buy and sell. But that's ok. He cites a study of 66,400 Merrill Lynch investors-those who traded least beat the active traders by 11-18% (xxi)!

Not only that, but those who invest in index funds don't have to worry about dealing with brokers and paying commissions. Plus the rates for managing these funds are much lower, less than 1%.

Most important? Over the long term, through market ups and downs, index funds have averaged a good 10% return (Farrell xxiv and other sources). 10%. That's almost twice what you could get for a high-interest savings account or a CD. Plus, you have barely any fees and no hassle about figuring out when to trade.

If you're interested in the different, simple strategies Farrell lays out, consider checking his book out from the library. Save the money on buying it and invest instead.

Now let's run the numbers. If you park that $10,000 in a fund which averages a 10% return, you'll have $67,275.00 in 20 years. And with 3% average inflation that money will be worth $37,248.54 in today's dollars. Thus, you'll have earned $27,248.54.

If you're saving for retirement, it's a good idea to invest in your index fund(s) through a Roth or traditional IRA, unless you work for a company which offers a 401(k). There's lots of information available on such accounts, so find out the tax benefits of each one. If nothing else use Wikipedia-last time I checked their IRA information was accurate. You can get (Roth) IRAs through some banks and investment firms.

Suppose you have a job with an employer matching your pretax 401(k) contributions. Great! Consider a Roth or other IRA for money you want to save after reaching your 401(k)'s annual contribution limits.

And for everyday life, consider investing through such index fund giants as Fidelity or Vanguard (the latter of which first made index fund investing available to individuals) or through discount brokers.

Which funds? One old but faithful strategy is to buy Vanguard's VFINX (stocks) and VBMFX (bonds) at a 50%/50% ratio. It's called the "Couch Potato Portfolio" and was developed by Scott Burns (Farrell 11). But do your research, just make sure the fund is an index and is offered by a reputable company.

Step 4 - The most important thing is-start now.

Why start now? Because interest compounds over time. The more time you give it, the better.

I'm 22. Suppose that I put $1,000 in an index fund earning 10%. In 40 years, I'd have $45,259.26 which would be worth $13,874.53! Isn't that great?

But if I wait until I'm 32 and take it out when I'm 62 (30 years), I'll only have $17,449.40, worth $7,188.92.

In Conclusion

Don't lose money to inflation or time. Give yourself the best future by starting it right now. Move along these steps as you can and work your way to slow-but-steady financial success!

(note: Mrs. Micah is not a finance professional. This article does not guarantee investment success but is intended as food for thought. Please do your own research.)

All calculations were done on MoneyChimp.com using their financial calculators.