Tag Archives: inflation

Unavoidable Trifecta of Investment Costs (UTIC)


There are costs that can be eliminated, like the constant buying of disposable razors, and costs that can merely be reduced. When it comes to investing your savings, there are 3 costs that are unavoidable: taxes, inflation, and fees.

These 3 costs are especially repugnant because they add up to a lot. Bill Gates, still one the worlds richest people, claimed in 2013 that he had paid over $6 billion in taxes. You lose about 2 cents for every dollar you have in a regular bank account every year to inflation. And fees are baked in to nearly every financial service you can think of.

Though you can never be free of any of these costs, you can certainly reduce how much you end up paying. You could get a financial adviser or an accountant. Indeed, legally avoiding taxes is a giant industry. But the more help you get, the more fees you incur. Generally, fees are lower than taxes, but not always.

If advisers and accountants aren’t for you, or if you at least want to better understand all this stuff, there is, of course, this blog ūüôā

In a nut shell, to minimize tax payments, put your savings in a Tax Free Savings Account (TFSA), where it can grow tax free. If you’ve maximized your annual TFSA contribution, there’s always Registered Retirement Saving Plans (RRSP).

The best way to avoid fees is to learn about how your money works on your own. The more comfortable you are with saving and investing, the less need you will have for more expensive services, like advisers or accountants.

Unlike the other two prongs of this trifecta, inflation is truly unavoidable. The only thing you can do is make sure your money is growing faster than inflation, which isn’t always the case with high interest savings accounts.


Financial Goals – What It’s All About


What am I saving money for?

For myself, this is the most important of all financial matters to get right. If I didn’t have a financial goal, I¬†would simply lack the motivation to save. Having a goal constantly reminds me of what I’m working for, and gives me a light at the (far) end of the tunnel. To me, it is the most reassuring thing to think about after a rough day, knowing a plan is in place, and underway and that I’m not simply spinning my tires.

As I mentioned in my first post, my personal financial goal is to become financially independent as soon as possible. How will I be financially independent? I will be living off the the interest of my savings! The S&P 500 has a long term annual return of 12.65%. If you had $1,000,000, that would be $126,500 in interest a year! Of course, once you factor in inflation, fees and taxes, you would be looking at a more modest, but still ample, return.

My goal helps me in more ways than giving me a sense of purpose, it also helps me know where to put my money. The S&P 500 is a great long term (at least 5 years) investment, which is what I need for my personal financial goal.

But what if your reason to save money is more short term? What if you are saving up for a down payment on a house, or something that will require you to spend your money within 5 years?

The S&P 500 is pretty safe as far as stock investments go. But it still has its down years, like 2008, the year of the great recession. Had you invested at the end of 2007, it would have taken 5 years for the S&P 500 index to grow back to the price you bought it at.

If you are investing for the short term, that probably means you have something fairly specific in mind you want to buy (house, car, vacation, etc). If you say “I want to save up $100,000 for a down payment on a house in 5 years,” you may value the added certainty of knowing your money will be¬†there in 5 years with a little bit of interest accrued, rather than be less sure your money will be there in 5 years, but with more interest accrued. The cost of safer investments is a lower return, and is a cost worth bearing if you¬†are looking for a more short term place to invest your money.

For shorter term investments, I suggest looking at government bonds, GICs, or even a high interest savings account. There are also many safe mutual funds and Exchange Traded Funds (ETFs) that will also achieve the same effect. They will not grow your money much, but they are very safe. The small amount they grow is better than nothing. Having anything offset the constant encroachment of inflation is important. And if you need a place to stash your cash short term, these are great savings options.



Compound Interest – The Double Edged Sword


In my first post, I mentioned that I make decisions to buy certain things by weighing having something¬†vs the value of that item in 20 years, with interest, for when I retire. I mentioned buying an Xbox One, let’s say that costs $500. If I spend $500 now, I have an Xbox One, but what if I instead put that money into my S&P 500 TFSA?

Well, it just so happens that I have a Google spreadsheet that tells you exactly what happens right here. The document assumes we invested $500 into the S&P 500, in our tax protected Tax Free Savings Account (TFSA), so we don’t have to pay taxes at all on this. It assumes the particular S&P 500 fund we want to invest in keeps its current fund fee of 0.08%, and inflation runs at 1.5% annually. You’ll see that our $500 investment grows to about $3900.

For me, $3900 can easily be enough to let me live comfortably for a month or two when I decide to retire. So Xbox One now, or 1-2 months of extra retirement in 20 years? As a PC gamer, the choice was easy.

I remember first hearing about compound interest,¬†it sounded like¬†you could turn on the ‘compound interest’ switch and start making serious money. Albert Einstein described compound interest¬†as “The eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”

Compound interest is the growth of your principle investment, and collecting interest on that growth in the next year (or compound period).

To illustrate with another example, let’s assume you have $1000 invested and your investment grows by 10% a year. Here is how that would work over 5 years:

  1. At the end of year one, your $1000 will grow by $100 (10% of $1000) to $1100.
  2. At the end of year two, your $1100 will grow by $110 (10% of $1100) to $1210
  3. At the end of year three, your $1210 will grow by $121 (10% of $1210) to $1331
  4. At the end of year four, your $1331 will grow by $133 (10% of $1331) to $1464
  5. At the end of year five, your $1464 will grow by $146 (10% of $1464) to $1610

Compound interest is the interest that grows off interest you’ve already¬†accumulated. Notice that after 5 years, your investment has grown to $1610, that is the base amount of your assets for year 6. Because of compound interest, it will take just over 7 years for your investment to double at a 10% annual rate of growth.

But compound interest can also work against you. Mortgages and credit card debt are good examples of that. If you have a credit card with an annual interest rate of 30% (the high end of interest rates in Canada currently), that 30% will be applied monthly or even daily by your credit card company. If it is monthly, you will be charged 2.5% (30% divided by 12 months) per month. As credit cards usually have a higher interest rate on overdue balances than most investments can return, this means that you can double your credit card debt in only a few years. This is one of the reasons why many financial advisers suggest paying off all your expensive debt before saving or investing your money.

If you are in the position of wanting to buy a house in Toronto or Vancouver,¬†and happen to have an amazing down payment where you’d ‚Äėonly‚Äô need a $500,000 mortgage, what would the (compound) interest be in 25 years? Using online¬†mortgage calculators, at a historically average 7% interest rate the banks will charge you, you’re looking at $550,623 in interest charges alone over 25 years. That is more than double the amount you borrowed.

Compound interest is the only way you can grow your savings and investments, it truly is the engine that drives the value of your savings up. But if you have a tough time controlling your spending, it also has the potential to cripple you in debt and force you to waste your time working only to pay off interest.

Fees – The Unavoidable Cost of Service

fund fees

Fees are one of the¬†Unavoidable Trifecta of Investment Costs (UTIC), taxes and inflation¬†being the other 2.¬†Fees are unavoidable because you really can’t even save your money, let alone grow it, without the services fees yield. Without banks, for example, you would have to store your paper money in a physical location in your house, which suddenly becomes vulnerable to fire, theft, and other bad things.

Types of fees to expect:

Bank fees / credit card fees РIt is really hard to function in our economy without a bank account. In addition to the physical protection and government insurance that blanket your money, banks provide loans to people who would otherwise not be able to launch their business idea, or buy their first house. Banks have many annoying fees (ATM fees, having a savings account with little money in it), but provide a lot of services that make buying things easier and safer. Certainly a necessary cost.

Stock trade fees РAs reviewed in my post about actually buying stocks, you will need a web broker that will execute your order. These typically cost from limited-time-free to $10 per trade. That means if you want to invest a bit of your money every month into the S&P 500, you might have to pay as much as $120 a year in web broker fees buying new shares.

Fund management fees – Every fund has a management fee that is charged to investors like us to pay for the management of the fund. This fee can include everything, include marketing and legal costs for the company that runs the fund. Generally, if the fund is human managed, you can expect fees of up to 1% – 2%.

1% – 2% may not sound like a lot, but it adds up to a lot over time. To illustrate, I’ve put together a spreadsheet in Google Docs that¬†has a table with a breakdown in money invested, investment growth, and fees. You can’t edit it from your web browser, but if you go to the top right and click File -> Download as, you can download the spreadsheet as your own .xlsx to play around with.

The spreadsheet can be found here, in it¬†you’ll clearly see how investing $200,000 over 20 years will result in a total take-home (before taxes) of $409,000 after $53,000 in a typical fund’s management fees are applied. If you play around with the spreadsheet, you’ll find that the more money you have invested, the more scary your fees will be.

Index funds, like Vanguards S&P 500, also have fees, but because index¬†funds are run by a fairly straight forward¬†computer program, humans generally aren’t involved. That makes index funds comparatively inexpensive, Vanguards S&P 500 has a Management Expense Ratio of 0.13%.

Financial adviser

Not everyone has a financial adviser, most don’t. But those who do will need to pay for them. Lots of large financial institutions will typically pay their financial advisers commission. Your financial adviser will probably take¬†a fraction of that 1-2% fund management fee, or they might take a cut¬†of any mortgage or other financial service they are¬†providing you.

I personally don’t like this payment model, it is one of the reasons why I decided to manage my finances myself. The problem is that obfuscating how your financial adviser¬†is paid will hide the fact that they are paid (and thus, motivated) more for selling you more profitable services, like insurance. And obviously, a financial adviser working and ABC Bank will only be able to help you with funds and services that ABC Bank provides, meaning you’re only getting the best products and services from ABC Bank, not the best products and services available.

Savings Accounts – The Usual Suspects


So, because of inflation, we know that we can’t just leave our money in a regular savings account. Your money does grow slightly in a typical savings account, usually by less than 1%, which is barely better than nothing, but still better than nothing.

Why do banks give you any interest on your saved money at all? It’s because they want you to put your money with them. Banks don’t just sit on your money and keep¬†it safe, they invest it in their various business endeavors (typically mortgages and other types of loans) and take whatever return on investment (ROI) for themselves, which will be much higher than 1%. So it’s in their best interest to have people save money with them so that they can invest it into something that offers them¬†a better return than 1%.

Banks are required to keep a certain amount of cash on-hand, but given that most people keep their savings with their banks and rarely make significant withdraws, they don’t need all your cash on-hand as only a very small percentage of deposits are withdrawn on a regular day. Of course, if times get tough and trust in banks or the economy plummets,¬†people will want their money in their hands and withdraw their savings at the same time as everyone else. That creates a major problem, as Greece experienced with their recent election, where the banks simply didn’t have enough money to give to people. But don’t worry, in Canada, if such a thing were to happen, the Canadian Deposit Insurance Corporation (CDIC) will cover you up to $100k¬†per account with tax payer’s money (though I’m not sure how that would work if the Canadian government was out of money too).

Some¬†banks have a high interest savings account, which is usually under 1%. The various savings rates are usually dependent on how much money you have with a bank, here is a breakdown of some of the banks’ current savings rates:

  • TD
    • Savings interest rates: 0.1% – 0.8%
    • If you have less than $5000, your savings will grow by 0.1% per year
    • If you have more than $5000, your savings will grow by 0.15% per year
    • If you have more than $5000 in TD’s High Interest Savings Account, your savings will grow by 0.8% per year
    • If you’re a youth with less than $5000, your savings will grow by 0.05%
    • If you’re a youth with more than $5000, your savings will grow by 0.15%
  • CIBC
    • Savings interest rates: 0% – 0.85%
    • If you have less than $5000, your savings will not grow
    • If you have more than $5000, your savings will grow by 0.85% per year
  • RBC (Royal Bank of Canada)
    • Savings interest rates: 0.05% – 0.75%
    • If you have less than $5,500, your savings will grow by 0.05% per year
    • If you have less than $5,500 to $25,000, your savings will grow by 0.1% per year
    • If you have more than $25,000, your savings will grow by 0.2% per year
    • If you have a Tax Free Savings Account (TFSA), your savings will grow by 0.75% per year
  • Scotiabank
    • Savings interest rates: 0.1% – 1.3%
    • If you have less than $5000, your savings will grow by 0.1%
    • If you have $5000 – $25,000, your savings will grow by 1.15%
    • If you have more than $25,000, your savings will grow by 1.3%
  • Tangerine (formally ING Direct)
    • Savings interest rates: 1.05%
    • Tangerine has many kinds of accounts, but their savings account seems to offer 1.05% to everyone

As you can see, it’s pretty tough to get much more than 1% interest on your savings at any bank or financial institution. To make it more difficult, the range in savings rates depends on how much you invest, CIBC gives you no interest for any savings that total less than $5000. To get a savings growth rate of 0.2% at RBC, you need $25,000 deposited with them.

I have mentioned how inflation makes everything cost more every year. Over the last 15 years, the average annual inflation rate has been 1.97% per year, which is significantly higher than any of the interest rates any bank will give you to grow your money. This means that even if you had money in any of these bank’s savings accounts, your money would still¬†lose about 1% to 2% of its value every year.

What this boils down to is that in Canada, you effectively lose money every year when it’s in any savings account. Banks still want you to invest with them though, they regularly offer incentives to lure your money into their accounts, usually with a limited time ‘high’ rate of return, currently between 2.5% and 3%. But buyer beware, those rates only last for a few weeks, then you are back on the regular low rates.

So what’s the solution? How does one protect the value of their money?

Let me answer with another question: How do rich people grow their savings?

Inflation – The Hidden Dark Horse


You remember when you were a kid and a chocolate bar cost far less than it does today? This phenomenon happens because of inflation, and the same thing that happens to chocolate bars happens to your money too.

I don’t see inflation talked about as much as I think it should be, especially¬†when it comes to personal finance. This blows my mind because every year¬†all money, including yours, loses a bit of value¬†to inflation. In fact, since 1993 the Bank of Canada has been¬†openly committed to an inflation target of 1-3%, meaning a little inflation is good for the economy in general, just not your savings.

Inflation is a big, complicated, abstract concept which is why I think it is so often overlooked. But after looking at various ‘high interest rate’ savings accounts, I started to think¬†that people not familiar with inflation are losing money when they think they’re gaining money.

To better illustrate inflation, let me offer a basic example:

You are king/queen of a small village of 100 people. To avoid everyone bartering, you decide to create a currency based on gold, you have one kilogram of gold and you decide to create coins for your 100 subjects. So you take your gold and make 200 royal coins. Your people are happy, they now have something that allows them to price their goods and services more accurately than if they were trading for other goods and services.

Your plan works well. The villagers find it easier to buy and sell goods, and thus easier to make money. But you only have 200 coins, and your inventive villagers start coming up with new ways to make money, new goods and services to sell and you soon notice a coin shortage in your economy. Your more successful inhabitants are saving coins from their successful business endeavors, taking fewer and fewer coins out of general circulation. You discover that of the 200 coins you made, only 100 seem to be exchanging hands regularly, making the coins more scarce, and thus more valuable to the point where one coin can buy a villager enough grain to feed a mule for a whole year.

So you decide to buy another kilogram of gold (perhaps by introducing taxes) and mint another 200 coins, doubling the amount of coins in your economy. Because so many more coins are now in general circulation, they are no longer scarce and one coin will now only buy a villager enough grain to feed a mule for only half a year. Those who saved coins before you introduced more coins would find that their savings have effectively been halved because they can now only buy half the goods for the money they had saved.

By doubling the amount of coins available, you’ve effectively halved the monetary value of all your coins. Inflation went up 100%!

The Canadian economy works on the same principle, except¬†it isn’t based on gold and is more sophisticated. In addition to introducing new money into an economy, rising costs in manufacturing¬†or a¬†commodity scarcity are also big factors in inflation.

The Bank of Canada is the institution that manages the Canadian Dollar; it issues new money and sets the interest rates. It also has a target inflation rate of 1-3% that it uses to steer the economy.

The Bank of Canada measures¬†inflation by measuring the change in the Consumer Price Index,¬†which is a “basket” of thousands of consumer goods¬†(for example:¬†a kilogram of Royal Gala Apples, a new Toyota Camry, a pair of Levis 501s, etc.) and tracks the price changes. In fact, the Bank of Canada has a handy inflation calculator that lets you see exactly what inflation has been. Using this calculator, I can see that in 2014, inflation was at 0.97%. In 2013 inflation was 1.48%. Since 2000, inflation has gone up 32.94% with an average annual inflation rate of 1.92%.

Looking at the inflation calculator, I see that $100 in 2000 would get me the same amount of goods then as $132.94 in 2015. Put another way, a chocolate bar that cost $1 in 2000 would cost you $1.33 in 2015.

Inflation means each year $1 will buy you less, so if you have money just sitting in a bank account collecting little or no interest,¬†you aren’t losing money, but as the cost of goods grows, the value of your money does not, and you will be able to afford less things as the years go on with the same amount of money.

To use another¬†example, if $11,000 was a median¬†annual salary¬†in 1950, and I worked for a year and managed to bank my entire salary (somehow avoiding taxes and the cost of living), I would have $11,000 in the bank today. Which won’t get me nearly as much as if I had today’s¬†median annual salary of¬†$45,000 in the bank.

If you have $1000 in the bank today, what do you think you’ll be able to buy with it in another¬†fifteen¬†years?

Next week, I’m going to look at various savings accounts and see how those “high interest” rates stand when you apply inflation.