The market is a scary place. If you decide to open up the Globe and Mail to check the daily news, you’ll find a stock market ‘ticker’ sitting smack-dab in the middle of the page. This is the equivalent to vending machines putting the most popular candy at eye level. Right now, with the current market situation, the tickers are often red, and from a psychological standpoint, red is a dangerous colour.
So in times of uncertainty like this, a common reaction is to revert to hiding your money under your mattress. Though it’s not a terrible idea to keep some cash on hand for emergencies, did you know that you are actually losing money by doing that?
Most people think they are protecting their wealth by putting it in a shoe box and leaving it alone, but in reality (and in market terms) that money is showing a negative return year after year. The principle is called the ‘Erosion of Purchasing Power’.
What is Purchasing Power?
Imagine your grandparents (or great grandparents) living through World War 1. 1917 was the highest inflation year in Canadian history at ~19%. What does that mean? The loaf of bread or jug of milk that cost $1 at the beginning of the year, cost $1.19 by Christmas. Inflation is the increased (or decreased) cost of goods and services over a period of time (usually a year).
1917 was an anomaly. We had just come out of the World War, the global economic landscape was changing, and a lot of policies were born out of that period of time. More recently, the government has strictly tried to maintain an inflation rate of ~2%/year.
Now, lets go back to the shoe box full of cash in the closet. Let’s assume that there is $10,000 in the box and it was put aside in 1970 as a way to start saving for retirement. Back in the 70’s, you could buy a house in Toronto for ~$30,000, so $10,000 was a substantial amount of money. The yearly income in Canada in the 70’s was averaging between $5,500 and $7,000/year (based on minimum wage being $2.60/hr).
First off, having $10,000 to put in a shoe box for retirement in the 70’s was a big deal. That was almost 2 years worth of salary. At the time, you could buy 1/3 of a home in Toronto, live without going to work for almost 2 years, or achieve a vast number of other objectives usually reserved for the top 1%.
But the box is in your closet collecting dust. Inflation is slowly raising the price of goods and services around you and you forget about the cash. Fast forward to 2020. You are ready to retire. You suddenly remember you stashed this great wealth in your closet and you go to collect it. Sadly, you see just $10,000 in a box.
The loaf of bread that cost $1 now costs $4. The land alone where you could have bought the $30,000 house is worth $800,000+.
Your $10,000 will afford you a nice vacation, but doesn’t come close to the basic income needed for a family to survive. The power that you had to purchase goods with that $10,000 has declined dramatically over the 50 years that it sat in a box.
How do you avoid inflation?
Short answer is that you can’t. Inflation is a result of a variety of factors including currency value, debt load, import/export ratios, interest rates, and taxation. The good news is that it can be counteracted. The new equivalent to a box in the closet is GIC’s (Guaranteed Interest Certificate). They are the ultra-low risk investment that will help your money keep pace with inflation.
But do you want all of your money to keep pace with inflation, or would you rather take some risk and have the land worth $800,000?
The Three Bucket Approach
This is some free advice, and I use this template with a lot of clients because it quenches many of their hesitations and concerns.
Imagine you have 3 buckets, and all of your savings will be in one of those 3 buckets. The first bucket is your bank account or cash in the shoe box. Its purpose is to provide a source of cash that can be accessed quickly in case of emergency. If you need to book a quick flight or get a repair on a car, this is where you turn to first.
Side Note: Many people accept credit cards as their “quick access” solution, but that more often leads to major debt problems.
The second bucket is your short term goals. The goals themselves are dependent on you as an individual, but the idea is to provide quick access (liquidity) while obtaining some growth for the future. often this bucket contains a portion of their emergency fund. It allows your emergency fund to reflect the changes brought on by inflation.
The third bucket is your long term goals. For some people, there would be very little change in how your long term and short term goals are invested, but generically, you can afford to accept more risk when you have a longer period of time. Higher risk should result in higher returns.
This approach is a foundational piece to people’s investment strategy, and a key deterrent to the erosion of purchasing power. For perspective, if the $10,000 from our shoe box simply kept pace with inflation (a non-adventurous goal), it would be worth ~$68,162.86. Back in 1970, $10,000 gave you options. In 2020, $10,000 doesn’t reach as far or present the same opportunity.
Now if we translate the conversation towards the future, what kind of freedom would you have if you let your money’s purchasing power erode? Are you helping your ‘future self’ accomplish their goals? Planning for the future is more than putting money into a box. It’s asking yourself: how will this money impact my family’s quality of life down the road? Do you want to see the opportunities diminish with time, or know that when the time comes, you’ll have to tools available to take advantage of whatever comes your way?