Especially trailing the Great Recession, many individuals are tempted to hold onto their savings in the form of cash or cash equivalents in an attempt to preserve their value. There’s no risk in this, right? In reality, this may not be the wisest decision to preserve your wealth, as the average inflation rate has traditionally hovered around 3%. This means that the dollar in your hand will lose 3% of its purchasing power within the next year; you will be able to buy 3% less stuff with your money a year from now. Yet, though it may seem counter-intuitive, this situation is highly preferable to the alternative—deflation—and nicely aligns with the Fed’s goals of stable prices. Investing the majority of your assets where you feel comfortable (whether that be bonds, ETFs, equities, etc.) and especially seeking a financial advisor’s advice is by far your best shot at preserving and growing your wealth.
Why is slight inflation preferable? Inflation is “the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling,” as the wonderful Investopedia explains. In order to facilitate this inflation, the Fed exercises an “elastic” currency, meaning that they print money out of thin air (the value of money is not tied down to a gold standard.) Although it may seem counterintuitive, this allows the Fed to rapidly react to changes in the economy and prevent the dollar from deflation, which is the worst case scenario. Deflation, which occurs when there is a shortage of money resulting in an overall fall in prices, is dangerous since it “results in lower prices being forced upon the market which are not the result of normal market forces” (“Why Deflation Is Bad And Inflation Is Good: Monetary Policy 101.”) This is really bad for people looking to borrow money, so essentially all of us if we someday wish to make a big purchase, because lenders will definitely want to hold onto their cash since it will be worth more in the future than it is currently. As you can deduce, deflation spells disaster for interest rates. If inflation goes up, interest rates can go up as well to naturally lower demand for borrowing money and keep the economy from hyper-inflation. But, interest rates are not able to go below 0%, thus deflation, and the economy is stuck in a downward spiral where no one wants to spend, much less loan out, money. To quote the previous article, “once an economy slips into a deflationary spiral, there is little the Fed can do, and that is why they deliberately error on the side of caution and generate a bit of inflation. It is simply an insurance policy against the destructive consequences of deflation.”
How do I beat inflation? Unfortunately, since most bank accounts offer really low interest rates for savings, usually around 1%, holding the primary amount of your wealth in cash means that since it’s not growing past 3% to make up for inflation, it’s shrinking. The Forbes article, “Why It’s A Bad Idea to Keep Your Retirement Savings in Cash,” highlights the reality that “in a sense you’re actually losing money every year. ‘The cost of goods and services goes up every year by about 3% on average, as inflation,” says David Blaylock, a LearnVest certified financial planner™ in Fort Worth, Texas. “If you’re earning 1% on your money in a savings account, you’re arguably losing purchasing power every year due to inflation. Growth isn’t even a possibility.’” To begin handling your assets with greater diligence, a good rule of thumb is to look at keeping about six to nine months of savings liquid in case of emergency. From there, assess your personal risk tolerance and look outward to investing and safeguarding your savings through slowly investing it back into the market where you feel comfortable. Luckily, in our developed society we have access to many great financial resources to guide us in this process, the foremost being a personal wealth advisor.
In conclusion, investing does not have to be a risky gamble embarked upon by the ambitious wealthy, rather it is a great way to safe guard against inflation risk while providing the opportunity to gain additional value on your savings.