Basic financial education tells us that saving is good and spending is bad. Much is often made of how some of the world's richest people, such as Warren Buffett, lead surprisingly frugal lifestyles.
But while a good savings habit is foundational to building wealth, you can certainly have too much of a good thing when it comes to putting away the pennies.
So if you're a rabid saver who puts any spare change you can find into a savings account or term deposit, you might want to rethink your strategy here. Your savings account might be costing you more than you think.
Savings accounts are important but will cost you all the same
To get things straight, there is nothing wrong with saving money. In fact, having a rainy day fund is a highly desirable thing. You never want to be caught in a situation in which you have a large unexpected expense with no means to pay for it.
Life is unpleasantly unpredictable at times and you never know when you might lose your job, have an expensive medical emergency in your family, or unexpectedly need a new car.
For these reasons, it's important to have at least a few months' worth of living expenses accounted for in your savings account. Unexpected expenses can lead to a nasty credit card treadmill that is difficult to escape if you're not prepared.
However, while saving money is important, it is not a great way to build wealth. Our financial system is built around the playoff between risk and reward. Put simply, the safer the investment, the lower the returns one can expect from it. A savings account qualifies as an investment since the bank tends to pay you interest in exchange for holding onto your money.
However, it is pretty much the safest investment out there. Most banks in Australia are regulated so prudentially that bankruptcy is almost impossible. Additionally, most financial institutions' products come with a government guarantee of up to $250,000. That means that if the bank does go under, the government will step in and make sure that up to $250,000 gets back to you.
Are savers losers?
But in exchange for this safety, your savings won't be attracting a very good interest rate. In fact, there's a good chance that your money will be going backwards in real terms.
Last week, we got a look at the latest inflation figures for the Australian economy. As we discussed at the time, Australian prices rose 4.9% over the 12 months to July, down from 5.4% for the 12 months to June.
This means that over the year to 30 July, everyone's money lost 4.9% of its purchasing power. Even if you manage to find a savings account that pays an interest rate of 4.9%, then your money is only treading water. And that's before accounting for the income tax you have to pay on the interest received as well.
So you can see why it's almost impossible to build wealth using a savings account.
Instead, a saver would have been far better off investing in 'riskier' assets like shares.
ASX shares trump cash investments
Over almost any long period of time, ASX shares have handily outperformed cash investments. As our chief investment officer Scott Phillips discussed just last month, "a hypothetical $10,000 invested in Australian shares in 1993 would have been worth $138,000 after 30 years. That's 9.2% per year".
In stark contrast, keeping your cash in a savings account would have left an investor with just $34,737 after those 30 years at an average 4.2% rate of return.
I know which asset class I would have preferred to have most of my wealth in.
So I have nothing against savers or saving as a practice. However, it's important to move on to investing in more productive assets once you have enough savings to feel comfortable that you won't be knocked on your back after an unexpected expense.
Every dollar you have in a bank account represents an opportunity cost of not having it in higher-returning shares. And that will cost you down the road if you don't act on it now.
