May 5, 2020
Written By: Andrew Hallam
My mother-in-law bought a 1-year CD (certificate of deposit) at her bank yesterday. She says she’ll earn 0.5 percent in interest. That’s slightly better than the national average. According to Bankrate.com the average 1-year CD in late April offered 0.45 percent for the year.
To my mind, she’s a savvy CD buyer. She shoveled money into CDs and savings accounts for the past 50 years. That might sound prudent. But it’s not the kind of risk I would want to take.
My notion might sound crazy– so let me explain. If you’re saving money for a down payment on a house or you’re keeping 3-6 months worth of living expenses aside, CDs and savings accounts make a lot of sense. But if you’re saving for retirement they’re a lot like running on a hamster wheel.
Assume you had $1,200. You plan to spend that money in a single day. Here’s what you want to buy.
- A case of toilet paper
- A new pair of pants
- A restaurant meal for your entire extended family
- New tires for your car
You’re a meticulous sort of person, so you note the prices of these things before your big day. They’ll cost exactly $1,200.
Now imagine you’ve decided to postpone this big day. With COVID-19 running wild, restaurants are closed, so you can’t enjoy the family meal. You put $200 in a savings account and the remaining $1000 in a CD that you decide to renew once a year.
Five years later, you decide it’s time to execute your plan. You withdraw the money from the savings account and the CD, including the interest you have earned. Your money has grown from $1,200 to $1,300, so you’re feeling pretty good. On average, you earned about 1.7 percent per year.
You buy the case of toilet paper. It costs more than you remember. You then buy the pants, which cost more too. At lunch, you treat your parents, your siblings and your children to a meal at your favorite restaurant. But the meals cost more than they used to. Then you take your remaining money and try to buy a set of tires for your car. No can do. You don’t have enough money.
What happened here? Five years before, you could have paid for everything with $1,200. Now you need more than $1,300.
In the example above, the $1000 in the CD would have barely kept pace with inflation, and the $200 in the savings account would have lost to inflation every month.
Simply, the $1,200 you stuffed into “something safe” lost money, in terms of buying power. That’s why an after-inflation return is called a real return. It’s the only thing that counts. It’s the only thing that’s real.
This might sound harsh, but it’s worth repeating. Unless you twist the laws of mathematics, you can’t make a real dime in a savings account or CD.
This might increase nostalgia for the good old days. I still remember opening my first savings account in 1980. I was ten years old, and my mom took me down to TD Bank. That year, my money gained about 11 percent. You might have earned a similar amount. But according to the CPI (Consumer Price Index), inflation recorded 12.52 percent that year. The typical CD matched that rate. But savings accounts didn’t. Much like today, savings accounts and CDs didn’t make a real profit. Those good old days weren’t that great.
Unfortunately, we can’t hide from what’s real. Consider the five-year period from January 2015 to January 2020. U.S. inflation averaged 1.82 percent per year. If you didn’t earn at least 1.82 percent per year, you lost money. Goods and services that cost $10,000 in 2015 would have cost about $10,943 at the beginning of 2020.
On the other hand, if you had equally split your money between a U.S. stock market index and a U.S. intermediate government bond market index over the same five-year period, you would have earned a real profit. According to portfoliovisualizer.com, you would have gained a compound annual pre-inflation return of about 6.83 percent. The real return would have been 5.01 percent per year (after inflation).
Between 1972 and 2020, there were forty-four rolling 5-year periods. For example, 1972-1976 was the first five-year period; 1973-1977 was the second; 1974-1978 was the third; 1975-1979 was the fourth; 2015-2019 was the forty-fourth. During all 44 of these rolling 5-year periods, money stuffed into savings accounts and CDs didn’t earn a real penny. For many people, such products represent a long-term risk they can’t afford to take.
In contrast, money split evenly between a U.S. stock index and an intermediate government bond index would have earned a real return in 40 of the 44 five-year periods.
Rolling Five-Year Periods
|In How Many 5-Year Periods Did CDs and Savings Accounts Earn A Real Profit?||In How Many 5-Year Periods|
Did A Balanced Portfolio
(50% stocks, 50% bonds)
Earn a Real Profit?
|44 Measured Time Periods||0/44||40/44|
You might wonder how the portfolio performed during the four 5-year time periods when it didn’t beat inflation. From 1972-1976 it averaged a compound annual return of 6.09 percent. From 1973-1977, it averaged 3.81 percent. From 1974-1978 it averaged 6.29 percent and from 1977-1981 it averaged 7.57 percent per year. In the bottom table, you can see how each of the 44 five-year periods stacked up against inflation.
|5-Year Rolling Period||50% Stocks|
|Inflation||5-Year Rolling Period||50% Stocks|
|1972 -1976||6.09%||7.25%||1994 – 1998||14.38%||2.36%|
|1973 – 1977||3.81%||7.91%||1995 – 1999||17.15%||3.04%|
|1974 – 1978||6.29%||8.75%||1996 – 2000||11.87%||2.54%|
|1975 – 1979||11.85%||8.16%||1997 – 2001||9.09%||2.18%|
|1976 – 1980||11.01%||9.27%||1998 – 2002||4.46%||2.32%|
|1977 – 1981||7.57%||10.09%||1999 – 2003||4.45%||2.37%|
|1978 – 1982||12.89%||9.51%||2000 – 2004||4.03%||2.46%|
|1979 – 1983||14.79%||8.47%||2001 – 2005||4.52%||2.49%|
|1980 – 1984||13.53%||6.60%||2002 – 2006||6.77%||2.7%|
|1981 – 1985||15.16%||4.85%||2003 – 2007||9.13%||3.03%|
|1982 – 1986||17.78%||3.29%||2004 – 2008||3.14%||2.67%|
|1983 – 1987||12.96%||3.41%||2005 – 2009||4.18%||2.57%|
|1984 – 1988||12.42%||3.54%||2006 – 2010||5.75%||2.18%|
|1985 – 1989||14.94%||3.68%||2007 – 2011||4.97%||2.27%|
|1986 – 1990||9.99%||4.14%||2008 – 2012||5.31%||1.80%|
|1987 – 1991||11.72%||4.53%||2009 – 2013||11.09%||2.08%|
|1988 – 1992||13.08%||4.8%||2010 – 2014||10.06%||1.69%|
|1989 – 1993||13.03%||3.89%||2011 – 2015||7.75%||1.53%|
|1990 – 1994||8.25%||3.50%||2012 – 2016||8.05%||1.36%|
|1991 – 1995||13.37%||4.29%||2013 – 2017||8.41%||1.43%|
|1992 – 1996||10.94%||2.83%||2014 – 2018||4.95%||1.51%|
|1993 – 1997||13.2%||2.60%||2015 – 2019||6.83%||1.82%|
|Sources of returns and inflation: portfoliovisualizer.com|
CDs and savings accounts don’t make money. Period. They aren’t designed to increase anyone’s buying power. That’s why, when saving for retirement, a conservative portfolio of low-cost stock and bond market index funds is a much better way to go.
(Note: Portfolios with higher stock allocations would likely outperform a portfolio with 50% stocks and 50% bonds, but portfolios with higher stock allocations would also be more volatile).
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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