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Is a savings account really safe? - Outside View by Asad Dossani

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Is a savings account really safe?
Mar 14, 2011

From the title of this article you may think I'm referring to whether a savings account in a bank is safe from the bank potentially going bust. While that is of course a real concern for some banks, this is not what this article is about. A savings account is often touted as a safe investment because you earn a guaranteed return. While a guaranteed return is certainly desirable, it does come a huge cost.

While a savings account provides a guaranteed nominal return, it does not guarantee a real return. The real return is equal to the nominal return minus the inflation rate. In fact, a savings account will generally provide a negative real return.

Consider the following hypothetical scenario: An individual invests Rs. 100 into a savings account that earns 5% interest. After one year, he has a balance of Rs. 105. At the same time, the annual inflation rate is around 10%. So what used to cost Rs. 100 now costs Rs. 110. So at the end of the year, the saver is actually worse off. He has 5% more money, but things cost 10% more. So he has made a real return of -5%.

The issue here is that the return on a savings account or fixed deposit is not high enough to keep up with inflation. Every year that money is kept in a savings account, it is continuously losing its purchasing power as long as the inflation rate is above the interest rate. So what are the alternatives?

Stocks and commodities are both asset classes that are much better hedges of inflation relative to a fixed deposit. Let's examine why this is the case. Starting with stocks, consider a hypothetical company. If prices are rising (i.e. inflation), then the company's costs and revenues usually rise too. Consequently, their profits rise along with inflation. This is true as long as inflation is not so high that it prevents companies from making investments. Thus, stock prices should tend to go up if there is inflation.

Commodities are generally considered to be good inflation hedges. Because the supply of commodities doesn't change much in the short-term, inflation increases tend to manifest themselves in higher commodities prices. This is especially the case for precious metals like gold and silver.

Of course, we know that stocks and commodities are risky too. They do go down and can lose value in nominal terms. They are certainly more risky than a fixed deposit. What is important to take away from this is that a savings account is not as safe as it seems. There is a high likelihood that purchasing power will be eroded over time. What is the best strategy to protect against inflation then?

If an individual has money to save for only a short period, it is wisest to use a fixed deposit as stocks and commodities have a risk of falling. If one wants to save money for a long period, it is worth keeping a portion of those funds in a diversified allocation of stocks and commodities, as this will be the best strategy to preserve one's purchasing power.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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