How much interest have you earned on your savings in the past five years?
If you left your money sitting in the bank, earning the official cash rate – then a $20,000 balance would have earnt you $2,161 in 5 years.
Not bad, right?
That is, until you calculate the opportunity cost of not investing that money.
Before we dive into that, let’s look at what’s happened to interest rates. Yes, we’ve heard they used to be higher…
In the past 12 months, the real return (the return adjusted for inflation) on term deposits has gone negative.
How did we figure this out and more importantly, how can you check your real rate of return for a TD? We’ve worked through a quick example of how to calculate the real rate of return on a 12-month term deposit:
|Interest rate offered by the Bank||1.50%|
|Minus 30% tax (the RWT for an NZ employee earning average wage)|
|After Tax Return||1.05%|
|Minus inflation of 1.50%|
|Real Rate of Return||-0.45%|
This means anyone paying 30% RWT on term deposits is going backwards financially.
The opportunity cost
Opportunity cost is a fundamental economic principle. It’s the sacrifice that arises when you make a choice, because with each option you choose, you’re saying “no” to a different option.
In other words, to enjoy the value of one thing, you must give up the value of another – it’s the value of what could have been.
Any sort of strategizing — whether financial, professional, or social — usually includes an evaluation of opportunity costs. This may be as simple as deciding whether you want Chinese or Indian for dinner, or more complex such as whether you want to rent or buy.
Opportunity cost plays a major role in your personal finances. How you spend your hard earned money corresponds directly with how successful you’ll be in your wealth building activities.
Spending money on a new car means you can’t invest that money. Equally, the same $500 can’t be invested in a savings account and an investment account at the same time.
Opportunity costs in investing
So what about when it comes to investing?
Instead of leaving your $20,000 in a bank account you decided to invest in an index fund in 2015. Over the 5 years to Dec 2019 you would have earnt $22,889!
The opportunity cost of leaving the money in a term deposit was over $20,000.
Sometimes you need savings
Of course the realities of saving versus investing cannot be oversimplified. There are many personal factors to consider, like whether you have an emergency fund or are anticipating a near-term big-ticket purchase. There are many good reasons for favouring greater savings in the present, even if it means earning less.
However, savings at the exclusion of investing can prove problematic over the long term.
Investing grows your money in a way that savings cannot match. Just look at the example above – a $2,161 vs. $22,889 return – and that’s just five years in.
With the forces of time and compounding, the spread between your savings returns and your investment returns grow exponentially wider.
The cost of not investing now
Someone who puts $1,200 a month into an investment account from age 35 could have $1m by age 65, assuming 5% average annual returns after fees. Wait 10 years to start contributing, and you’d have to put in more than twice as much a month to reach the same goal.
In other words, the earlier you start investing, the greater your ability to reap the rewards of long-term market gains.
Conversely, the longer you say “not yet” and wait for “someday”, the more you have to contribute later on just to catch up. Therein lies the danger of waiting for “that market dip” or “for an election to pass”.
Thinking about a distant retirement future or wealth goal can seem pretty intangible – so try thinking about it this way.
Now think about how many hours, days or weeks would you have to work to make up the $20,000 difference between investment and savings returns outlined earlier. How about the potential half-million-dollar difference of waiting another decade or so to start?
The opportunity cost of not investing now is significant and very real. Time is the greatest money-making asset an individual can possess.
Savings is (not always) safer
We know that outside of KiwiSaver, the majority of Kiwis don’t tend to invest. Instead they opt to leave their money in the bank or a term deposit. The most cited reason for not investing is the notion that keeping money in savings is a safer bet for protecting wealth.
And given that markets move up and down on a daily basis, the recent memories of the GFC and now COVID-19, it’s easy to understand why investing may seem daunting. However, those who have invested have also experienced the significant market gains in the years since the financial crisis and in the COVID-19 recovery.
What’s important to remember is that these larger corrections occur infrequently and are part of the course of investing. Time and patience is key, whilst making sure you don’t respond to the noise of media headlines.
The savings danger
Savings sitting in accounts with interest rates of 1 percent or less, actually end up losing value over the long-term due to inflation. You can argue that keeping all your cash tied up in savings is more dangerous or “risky” to your financial health than smart investing.
Investing is an opportunity to outpace inflation and reap the benefits of growth over the longer term. Which will ultimately lead to achieving your long term financial goals.