The Hidden Tax of Inflation: How Cash Shrinks Your Wealth

“Invest you must. The biggest risk is the long-term risk of not putting your money to work at a generous return, not the short-term (but nonetheless real) risk of market volatility. “ John Bogle

Introduction

When people talk about investing they think about numbers and charts (or bull markets and bear markets). What is often missed is the element of emotion.

There are those of us that have an interest in the subject of investing. We view it as an opportunity to better our lives, and an engine to reaching financial freedom. There are also those who view it in a negative light. To them it may be something to be avoided, or just not discussed. This mentality around the subject usually originates from a bad personal experience. You have probably heard an individual in your life say a phrase like “I don’t buy stocks, that’s gambling”. This phrase is usually followed by a story about how their uncle lost his whole life savings “investing” in fill in the blank company. Although these stories may very well be true and obviously left a bad taste in the person's mouth. The people involved often extract the wrong lesson…they try to protect their money at all costs.

This protective mindset leads people to hoard their money in a savings account, and ignore the subject of investing all together. In return they may collect some interest with the promise that their money is “safe” (and banks are more than happy to make you feel “safe”…for a price). The number in their account will gradually increase over time, albeit slowly. This provides them with a sense of security because well… at least they aren’t losing money right?

In doing so they avoid the inevitable ups and downs of investing in the stock market. But most importantly for them they avoid being the protagonist in a similar horror story to that of their sorry uncle. Unfortunately, for people the biggest risk is something that people often fail to think about…enter Inflation.

Inflation Explained

Inflation is essentially the rise in prices over time. To make this relatable think about the everyday things you spend your money on such as groceries, gas, rent, and clothing. When the cost of these items increase relative to the same time last year or last month that is inflation. If prices decrease, it's called deflation. A perfect example of what many of you may have felt between 2022 and 2024. Prices skyrocketed in several areas such as rent, groceries, gas, and so on. This ultimately contributed to the cost of living crisis that many young Canadians currently find themselves in.

Governments and central banks aim to keep inflation around 2% annually to maintain economic stability. Despite these efforts:

• In the 64 year time period since 1960 the rate of inflation has averaged 3.8%.

• Between 1965 and 1991, the rate of inflation was never below the 2% target with a low of 2.32%, and a high of 12.49% in 1981.

• Throughout the 2000’s the inflation rate remained close to the 2% target up until 2021.

• In 2021 it reached 3.4%, 2022 it was 6.8%, 2023 it was 3.88%, and 2024 is was 2.4%. (see Figure 1).

Figure 1

Inflation matters because it erodes purchasing power—what your money can buy. For instance, $100 in 1960 would only get you $9.76 worth of the same items today. So, while the number in your bank account may grow (ie. nominal value returns), it doesn't necessarily mean you're financially better off, if inflation outpaces your savings returns (real value returns).

How to Beat Inflation ?

In order to avoid losing this battle with inflation the first obvious step is to ask for a raise from your employer… Hence why labor disputes often involve a union asking for a “cost of living” increase. This is just another way of saying “we would like a pay increase that keeps up with the rate of inflation”. Just think about how many strikes have occurred between 2021 to 2024. More than you or I have seen in a long time.

But the less obvious question that needs to be asked is what about the money you already have saved?

In order to win this battle you have to make a return on your money that is higher than the rate of inflation. There are several ways to make a return on your money but not all of them accomplish this goal. Outside of a piggy bank, or under the bed the commonly viewed “safest” place to put your money for the average person is in their bank account. Does this accomplish the goal of beating inflation?

Recently (and likely in the future), no.

Over the long term, maybe… But not very well.

Let’s use EQbank’s high interest savings account to illustrate this point. They consistently have one of, if not the highest rate, on a saving’s account in Canada. In 2020 the interest rate was between 1.5-2.45%, 2021 it was 1.25%, in 2022 it was between 1.5-2.5%, 2023 it was 2.5%, and 2024 it was between 1.75-2.25%. Over the course of this five year time period with your money sitting in the “safe” savings account you would have lost ~6.25% to inflation (see figure 2). And that’s only if you were savvy enough to look for the best rate throughout this time period, which most people don’t do. Other banking options would have produced significantly worse returns.

Figure 2

Now obviously this is an extreme example because 2021, 2022, & 2023 has been a period of high inflation above what we have seen since the 1980’s. So let’s extrapolate this data over a typical investment lifespan of 40 years (Figure 3). In this example I used the targeted inflation rate (ie. 2%). I compared two different money management strategies. The “safe” high interest savings account. And the “risky” stock investment using a low cost S&P 500 index fund/ETF.

Figure 3

As you can see after the 40 year time period the stock investment strategy significantly outperforms the high interest savings account (ie. >7x the return). What should not be missed in this example though is that over the entire 40 years both strategies would involve the same amount of deposits (ie. how much you put into that account).

And what is that amount? $130,000…Less than the inflation adjusted balance of the high interest savings account. That is losing money if you ask me…

How’s the saying go again… Short Term Pain, Long Term Gain.

Investing in the stock market doesn’t seem so “risky” after all now does it?

If you liked this post you may also like:

• [Should You Hire a Financial Advisor in Canada?]

• [The Best Investment You Can Make is in Yourself]

• [5 Tips On How to Survive a Stock Market Crash]

Disclaimer: The information discussed in this blog is not financial advice, and is meant for educational purposes only. Please consult a personal financial expert before making any financial decisions

Citations

• Bogle, J. C. (2017). The little book of common sense investing: The only way to guarantee your fair share of stock market returns. John Wiley and Sons, Inc.

• EQ Bank savings account interest rate history. Canadian High Interest Savings Accounts. (n.d.). https://www.highinterestsavings.ca/profile/eq-bank/savings-account-rate-history/

• Inflation rates in Canada. Worlddata.info. (n.d.). https://www.worlddata.info/america/canada/inflation-rates.php#google_vignette.

• Investment returns calculator (Canadian). (n.d.). https://www.cchwebsites.com/content/calculators/CAInvestmentReturn.html.