The Importance of Saving Money - AlwaysWealthy

The Importance of Saving Money

We’ve all learned about the importance of saving money, whether it’s from our grandparents, teachers or financial advisors. Despite this, most people live paycheck to paycheck. Why is that the case? Is the advice we are getting bad? In this article, we discuss the importance of saving money, explain why saving is hard and share some unconventional tips to help you save money.

Table of Contents

The Importance of Savings in Life

In a healthy economy, consumption and investments are based on income or savings. Using credit to consume or invest is possible as well. But debt is nothing else than borrowing from the future. Once the debt has to be repaid, it must be done with income or savings.

Saving allows people to build wealth. If we live paycheck to paycheck, we are trapped in a grind that requires us to work to generate income for most of our lives.

The Importance of Saving
Don’t underestimate the importance of saving money

Money can be seen as a way to store our time and energy. Without savings, we have no excess time and energy stored for a rainy day or when we want to stop working and retire. In the absence of savings, we are always financially dependent.

Saving is a prerequisite for financial independence. When our income is higher than our expenses, we can save money. And this money can be used to build wealth.

Financial Independence and Building Wealth

Wealth can be seen as the number of days you can live off of your savings or investments. If you were to quit your job or close your business today, how many days could you go without having to get another job or start a new business? The answer to this question will show you how much wealth you have built.

If your living costs are $3,000 a month and you have saved $30,000, you could survive without income for 10 months. But if you had $300,000 saved, you could survive for 8 years.

The importance of saving money for the future becomes apparent in the context of building wealth. Without savings you can’t become financially independent and build wealth.

Why Inflation Punishes Those Who Save

Now that you understand the importance of saving money, let’s take a look at why most people fail at saving significant amounts of money today.

Did you know that it takes the average American almost twice as long to save for a house today than it did in 1960? The reason for this is inflation.

Inflation is when the prices of consumer goods and assets increase over time. Most central banks aim for a 2% year-over-year inflation. They do this by expanding the money supply. When there is more money in circulation than there are goods and services, the prices of existing goods and services will increase.

This isn’t an accident but something all central banks want. However, it means that the purchasing power of your money is reduced by 2% every year.

If you save $1,000, it will only buy you $980 worth of goods and services next year. In another year, it will only buy you $960 and so forth. In other words, your money loses value with time. Over a 50-year period, your money loses half of its purchasing power.

The reason central banks aim for 2% inflation has to do with how our economy works. Large parts of our economy rely on credit today. Inflation benefits those who borrow money.

But it punishes those who save money. In order to stimulate the economy, central banks want to prevent that people hoard their money. Without spending, there is no economic growth. Inflation can be seen as an indirect tax on cash. Another way of looking at it is as an incentive to spend money and buy goods and services.

The Importance of Saving Money and Having Low Time Preference

People that focus on consumption and their immediate wants and desires have a high time preference. Inflation disincentivizes saving and encourages high time preference.

On the other hand, people that prioritize saving money, and are willing to sacrifice wants and desires today in order to build a better future tomorrow, have low time preference.

The reason why saving is hard is because inflation incentivizes borrowing and spending over saving. Nevertheless, saving is important because it’s a prerequisite to financial independence and wealth.

If you borrow money and spend it, it’s better for the economy in the short-term. But what about you as an individual?

While inflation will erode your savings, it is still important to save. You just need to do it in a way that protects you optimally from inflation.

The Big Challenge With Saving Money

The most difficult part about saving is that wages often don’t increase fast enough to keep pace with inflation.

In 2022, inflation hit a 40-year high in the United States and peaked at 7.5%. This is significantly above the target 2% that the Federal Reserve is aiming for.

Inflation rates in Europe and many other countries around the world have increased as well.

With savings accounts having almost zero percent interest rates, you are losing money by keeping it in the bank. To clarify, you’ll still have the same amount of money. But the purchasing power of the money decreases.

Every year that you keep your money in the bank it will buy you less goods and services. Even if you withdrew the money and stored it under a pillow, its purchasing power would slowly erode.

What’s the solution?

Why Investing is the New Saving

Prior to 1971, inflation was mostly not a problem. There were even periods where money increased in purchasing power.

People could hold their money in high-yield savings accounts or buy government bonds with a yield above inflation.

But nowadays interest rates are below the inflation rate. If you keep your money in a savings account that pays 0.06% interest and the inflation rate is 7.5%, you are really losing 7.44% a year.

Even if you buy government bonds with a 2% interest rate, you will be losing 5.5%. Whenever your rate of return is lower than inflation, you are losing purchasing power.

This is why investing has become the new saving. Savers are forced to become investors. And investors are continuously pushed further out on the risk spectrum.

What Should You Invest In?

In order to save money in a way that preserves your purchasing power, whatever investment you choose must provide a higher return than inflation.

Another way of thinking of it is that your investments must outpace inflation.

The good news is that there is something called asset price inflation. Just like the prices of goods and services increase, so do the prices of assets.

This is why inflation punishes people that live paycheck to paycheck or save money, and benefits rich people that own assets like real estate, stocks and art.

Inflation increases income and wealth inequality. Saving is a losing game under these conditions. The only way to save money while preserving your purchasing power is by investing.

The Importance Of Saving Money And Investing

Keeping money in a savings account or investing in bonds is less volatile. But over a longer period of time, the value of your money drops.

Investing in assets like real estate, stocks, art, precious metals and scarce commodities can be volatile in the short-term. You are likely going to encounter price swings. And if you are wrong about your investments, you might lose money.

But if you are right about your investments, their value will increase in the long-term and keep pace with inflation.

If you select the right investments, you might be able to outpace inflation. In this case you are multiplying your money and growing your purchasing power over time.

It’s hard to pick the right investments. But anyone who is serious about saving not only in nominal terms, but also their purchasing power, needs to start learning how to invest.

Consider Doing This if You Already Have Savings

If you have already saved up some money, you might want to consider making a lump sum investment.

It’s not recommended to invest any money that you might need in the short term, such as money set aside for taxes or upcoming expenses.

And if you’re saving for a home, it depends on how long your time-horizon is. Due to the short-term volatility of investments, it’s probably best not to invest any money that you need in the next five years.

Otherwise you might be forced to sell your investments at a loss if you need money during a market downturn.

Investing is a long-term game. It’s about buying assets you understand and believe in, and holding them for a very long time. This is why a 5-year or longer time horizon makes sense.

Saving and Dollar Cost Averaging

If you haven’t saved a considerable amount of money yet and aren’t able to make a lump sum investment, you might want to consider dollar cost averaging.

Dollar cost averaging is an investing strategy where you set aside a fixed amount of money every day, week or month and invest it.

For example, you could set aside $50 a week and invest it in an Exchange Traded Fund (ETF). Or you invest $500 a month in a few different stocks of companies you believe in and understand.

Dollar cost averaging requires discipline but its a great alternative to traditional saving strategies. Instead of keeping your monthly savings in your bank account, you invest fixed amounts at fixed intervals.

Is Bitcoin the New Savings Account of Millennials?

A lot of people have recently talked about bitcoin as an alternative to savings accounts.

If you will, bitcoin can be seen as a “savings account in cyberspace”, as Micheal Saylor from Microstrategy describes it.

While bitcoin is volatile, it has been the best performing asset in the last decade. Due to its limited supply it is deflationary. Unlike most currencies, its purchasing power is expected to increase with time.

Some people like to dollar cost average into bitcoin and buy a small amount every day, week or month. As with every investment, it is important to do your own research and understand how bitcoin works before putting any money in it.

Saving Money for a Rainy Day

Despite saving being disincentivized by inflation, it is probably not a bad idea to keep some money in your bank or safely stored somewhere.

Having cash set aside for a rainy day is always a good idea, even if your purchasing power decreases over time.

Cash is also great when there is a market drawdown. When markets drop, you will be less inclined to panic sell your investments at a loss.

Instead, you can buy assets at cheaper prices as long as you believe they will recover. Especially during the Great Depression in the 1930s, many people regretted not having more money set aside to buy stocks and real estate properties at bargains.

As with all money management and investing, you need to assess your risk tolerance, do your own research and come up with position sizes that you are comfortable with.

Holding cash and owning assets makes sense. It’s all about combining saving and investment strategies in a way that fits your goals and risk appetite.

But one thing is for sure: Saving the traditional way is dead.

March 9, 2022