Negative Real Return: What is Your Real Rate of Return?
We all know (or should know) that having an emergency fund is a good thing, and I think most people would agree that the best place to keep your emergency fund is in a high yield savings account or a short-term CD. However, I try not to keep a lot of money in my emergency fund — or any savings account for that matter. Why? Negative real return. Basically, inflation takes more away than you gain from the low interest rate offered by these accounts, resulting in the reduction of value of your savings.
I think the best way to demonstrate this concept is with a real life example:
- The best savings account rate is 1.51% APY
- The Consumer Price Index (CPI) for April 2010 vs. April 2009 is 2.2%
In this case, if you started an emergency fund by putting $10,000 in your Everbank account in April 2009, you would have $10,151 in your account after a year. Unfortunately, things that used to cost $10,000 in April 2009, would cost you $10,220 in April 2010. In other words, your money worth less than it used to a year ago — 0.69% less to be exact — and not to mention that you have to pay taxes on the $151 “gain”.
Better Than High Yield Savings
If saving money in a high yield savings account is a losing proposition, what are some good ways to deal with this? Here are a couple of ideas to make your money work harder:
- Pay down your debt. Consider paying off high interest debt (e.g., credit cards, personal loans, car loans, etc.) at an accelerated pace instead of adding to your savings. Paying down debt guarantees you a “gain” equal to the finance charges, which are much higher than what you can earned from savings. Personally, I keep a small emergency fund handy and pay down my debt as aggressively as I could.
- Buy TIPS. Treasury Inflation Protected Securities are the safest investments you can make that guarantee a real rate of return (i.e., positive return after adjusted for inflation).
- Invest your money. One of the reasons why experts advocate investing your retirement fund in the stock market is the ability to achieve greater than inflation growth.
- Put income producing assets into tax-advantaged accounts. One way to avoid taxes on your phantom gains is by putting your income producing assets inside your retirement accounts, such as Traditional IRA or Roth IRA, while putting appreciating (but non-income producing) assets outside of these accounts.
These are just a few ideas I came up with while putting this article together. Please chime in with other suggestions. I’m interested to know how other people deal with negative real return in practice.
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