If you’re one of the millions of people that uses a bank account to save money, then you’re actually losing money each month. That’s because the rate of inflation is actually higher than the yields on savings accounts, CDs and even Treasury bonds. Here’s what we mean.
If you have money invested in a savings account or a certificate of deposit, you are actually locking in negative real returns. Here’s how it works. Let’s say that you are earning 1% on your savings account or CD but that inflation is 3%. The truth is, right now, savings accounts pay less than that and inflation is actually higher than that. Anyway, let’s say you have $10,000 in your savings account. After one year, you will have $10,100. However, because of inflation, that $10,100 will only buy you $9,806 ($10,100 / 1.03 inflation factor) worth of goods in todays dollars. That means that you are actually losing almost $200 in buying power by investing in savings accounts and CDs. In this case, the loss is 2% (3% inflation minus 1% return). However, in reality, many banks are paying only 0.3% and inflation could be as high as 4%, especially on the goods that the average person buys. That means you could really be losing as much as 13 times the amount the bank is paying you for your savings rate.
Furthermore, it’s not just savings accounts that are losing money right now. If you invest in Treasury bonds, you could also be locking in negative real rates of return. That’s because 10 year treasury bonds are paying less than inflation right now also.
So if you thought you were playing it safe but now realize that you don’t want negative returns, what can you do to hedge against inflation. First, you could consider buying TIPS, which are treasury inflation protected securities. These securities guarantee a return of at least the rate of inflation, and the rates change each quarter with the published inflation rate. Alternatively, you could buy into some diversified high quality dividend paying stocks. There are hundreds of mutual funds and exchange traded funds that specialize in large cap, stable dividend paying stocks. While these funds are more volatile than a savings account, they offer yields as high or higher than the 10 year treasury bonds (at least at the time I wrote this). On top of that, you have upside for any increases in the stock price. And if inflation gets higher, most of these companies have pricing power to pass the increases in inflation onto their customers. That means that they are also a hedge on inflation themselves.
Regardless of how you handle your savings, this is a remarkable time in history. Interest rates are so low that they are actually negative when compared to inflation. This is something that hasn’t happened in over 60 years.