For the majority of millennials, opening a savings account is a common way to hold and manage cash because of the perception that savings accounts are the most secure way to build a nest egg or save for a rainy day.
However, the cash in your savings account may be at risk due to the cumulative effects of inflation. When interest rates are low and inflation rates are high, you could be losing money and not even know it. This means you would need to keep adding cash to your savings account in order to get back what you put in.
A smarter way to build your nest egg is to grow it over time. Here at WealthJar, we can help you put your money to work by choosing the right risk/return ratio based on your investment goals and unique time horizon.
Why excessive risk aversion can hurt you in the long run
Your WealthJar advisor has a fiduciary duty to advise you on the proper amount of risk to take in order to reach your financial goals. While all investments carry a certain degree of risk, it can be mitigated and managed with expert advice and a diversified portfolio.
One significant, often overlooked area of risk is inflation. Due to low interest rates, savings accounts are especially susceptible to the detrimental effects of inflation. Yet, despite this, they are often looked at as a “safe” place to keep savings.
This perception may be explained by our generation’s exposure to the Great Recession that began in 2007 and didn’t end until 2009. Or maybe it’s our aversion to the notorious Ponzi schemers that ran off with our parent’s cash.
In academia, it could be explained by the Prospect Theory, which notes that excessive risk aversion forces people to focus more on avoiding losses than on achieving gains. In other words, many investors find it harder to lose something they already had, rather than lose something they never had in the first place.
Another reason people choose to put their cash into savings is that we usually lean toward what we already know. This phenomenon is referred to as Familiarity Bias. As it pertains to savings accounts, many people feel comfortable keeping their cash at their local bank because the bank is familiar and the concept of a savings account is easy to understand.
What this boils down to is that excessive risk aversion and certain biases can prevent you from investing wisely and you may end up losing out on potential return from your nest egg.
How inflation hurts your purchasing power
Inflation erodes the cash sitting in a savings account by reducing your purchasing power over time. For example, if you have $100 sitting in a savings account and the interest rate is 2%, you would earn $2.00 each year. However, if the inflation rate is at 4%, you would ultimately be losing $2.00 a year in purchasing power. This means you would have to add $2.00 to your account each year to get out what you put in.
Bottom line, if your interest rate is not at or above the rate of inflation, your savings account is losing money. You would need to keep adding to it to make up the difference.