Why saving is getting you nowhere

Let’s say you made a declaration to cut down on your routine smashed avo shenanigans because some rich prick told you that delicious green mush is the real reason you can’t afford to own real estate (#okboomer) and you’ve instead opted to set aside more of your fortnightly wages into a savings account to buy yourself a big old house (tent) 2 hours’ drive from your place of work. You want your house (tent) to be large enough to fit a decent sized shoe box to store all your not-so-flattering German sandals.

Here’s why that won’t work.

Cash is not king

When investors say they’re investing in ‘cash’ or in the ‘money market’, they’re effectively setting money aside in some sort of account or fund which bears interest. The best interest rate (excluding introductory rate offers) you can currently get on the market for your hard-earned dollarydoos is just over 2%. These savings accounts often come with strict criteria you must adhere to in order to earn any ‘bonus’ interest which will get you across the 2% figure. This criteria may include limited to no withdrawals in any given month and minimum deposits, both of which encourage fantastic savings habits. However, ask yourself, am I really feeling satisfied with my 2% return? If you look back across all of financial history, you’ll understand that 2% is an abysmal figure to be yielding on your money.

You are likely yielding less than inflation

“But I’m a savvy saver, my cash sits in one of those ‘high’ interest savings accounts so I’m beating inflation right?” Well yes. And no. But mostly no. Here’s why. Your gross (before tax) earnings may be outperforming inflation (see Economics 101 for a discussion on inflation) but your net (after tax) earnings are likely losing this fight. Let’s walk through an example.

Stu earns $70,000 per year and his marginal tax rate is therefore 32.5%. Stu is smart. Stu has said no to smashed avo and birkenstocks for quite sometime and he’s saved himself a hefty $20,000. Stu is relatively risk-averse so he sets aside all his savings in a ‘high’ interest savings account yielding 2%. Australia’s inflation rate currently hovers around 1.8% and for argument’s sake, let’s say it remains that way for the next year. In one year’s time, Stu’s $20,000 has effectively lost $360 worth of buying power – it’s essentially then only worth $19,640 in today’s dollars. However, he’s earned $400 in interest. $400 is obviously higher than $360 so he’s definitely outperforming inflation but Stu has to pay tax on his interest earnings at 32.5% (plus the medicare levy but we don’t need that to prove this point). His net earnings are therefore only $270. Inflation is outpacing his interest earnings by $90.

The capital gains discount

If you were to invest in an asset like shares in a company or real estate and you hold your investment for more than 12 months, so long as you meet certain eligibility criteria, you are automatically entitled to a 50% capital gains discount. This means you only pay tax on half your profits. The Australian government introduced the CGT discount to (a) incentivise investment (so that money is being used productively and therefore contributing to society) and (b) to compensate investors for how inflation affected the value of their assets. This compensation point was supposed to compensate investors for the harsh effects of inflation on assets over a long period of time (say 30 years) but I imagine somewhere in some cabinet meeting, a politician said, “screw it, it’s too hard to pro rata it, just give them the whole discount from the 12 month mark” – whoever you are mate, I’m a huge fan of your minimal effort philosophy and I’m pretty sure we’re soulmates.

Applying what we’ve just learned about the CGT discount to interest earned in a savings account, if the discount applied to interest earnings, Stu would pay 32.5% tax on half his earnings ($200). As a result, his net interest earnings would be $335 and he would still be losing the fight against inflation but only by $25. These numbers might not seem all that significant but we’re only comparing against inflation here. Imagine how bad the numbers will look when you consider returns against what some other asset classes are returning. Well you don’t have to imagine – see below.

What gives, Australian government?

Now, an argument can be made (and it will be made, by yours truly), that the tax code as it stands indirectly discriminates against people from lower-socioeconomic backgrounds because the middle and upper classes in society are more likely to invest in riskier assets such as shares and real estate because they are more likely to be able to afford downside risk (i.e. when a ‘dysphemism for feces’ hits the fan). The middle and upper classes in society are also more likely to be more financially literate and therefore more aware of other avenues of investment (an unfortunate consequence of wealth inequality I’m idealistically (and perhaps naively) trying to fix with this blog). The lower class on the other hand, is far more likely to direct any excess discretionary income into a savings account. I don’t expect this article to ever be picked up by someone in charge of tax reform but if you’re reading this Mr Tax Man (or Woman) – like, come on – savers are already suffering as a result of the lowest interest rates on record, give them a break.

Well how should I invest my money then?

I don’t hold an Australian Financial Services Licence and even if I did I wouldn’t tell you where to invest your money, because it’s none of my business and hey, I could be wrong. However, I can state some facts. You do with the below information whatever you wish:

  • read Accumulating assets, it’s good stuff and so is my humility;
  • the ASX 200 (an index tracking the top 200 ASX companies) returned ~21% last calendar year and some international indices performed even better;
  • the Sydney and Melbourne housing markets returned ~8% last calendar year (and keep in mind housing is almost always geared which means amplified returns (and losses) – see Leverage);
  • gold returned ~18% last calendar year; and
  • I’m hearing interesting things about people profiting off limited edition sneakers?

Do not fall behind

The main reason I’m concerned with interest earnings is because if everything you have is tied up in a savings account, you’re falling behind very, very quickly. We learned in The time value of money that investment returns compound so if Stu was to average a 2% yield over the next 10 years on his $20,000, his gross dollar return would be ~$4,380 but if he was to average an 8% yield (say in the share market or in property) over the next 10 years, his gross dollar return would be ~$23,180 (both figures are before inflation). That’s a difference of almost $19,000!

Let’s throw in gearing and make the example worse just in case this article hadn’t quite killed the sweet weekend vibes yet. If you’re super keen on that big old house (tent) and that house (tent) costs $800,000 today and it takes you 5 years to save a deposit, by the time you’re ready to buy, the same house returning 10% every year (don’t even laugh, we’ve seen it happen) will be worth ~$1.288 million (before inflation). Do you really think you’ll be ready if your deposit is yielding 2%? Obviously I know that if you’re saving across a 5 year period, you’re constantly contributing more of your salary towards this savings account but I’m sure you understand my point. You cannot be complacent with your money because you will lose in the long-run. This is the worst time in history to be a savvy saver.