I have some money saved up and it is earning really low interest rates. The rates are so low that I am losing money due to inflation. How can I grow my savings?
In finance, investors are (generally) rewarded for taking more risk. Risk can be understood as temporarily or permanently loosing a portion or all of your money. The reward is bigger returns on your invested money.
Saving accounts have virtually no risk (up to the 100k EUR insured amount within the EU) therefore they have low returns, specially in a low interest rate environment.
To meaningfully grow your money you will have to consider investing in the stock market. When you invest in the stock market you own a part of a company – a share. Because of your ownership you are entitled to receive periodic payments from the company – dividends. Apart from the dividends you can also make money by selling your shares when the company becomes more valuable.
There are many ways to invest in the stock market. I think the best way for most investors is to buy index funds and hold them for a long period of time. Index funds collect money from multiple investors and invest it into hundreds (sometimes thousands) of companies with the aim of giving you the returns of the whole market. Index funds which are passive – they only aim to mimic the returns of the market by holding all companies – contrast with active funds – which try to outperform the market by choosing specific companies.
Here is why I think index funds are great:
- Great returns – The long term average annual return (after inflation) for the S&P 500, a popular index for the US market, is between 6% and 8%. That means that it would take you between 9 and 12 years to double your investment due to the power of compounding .
- Low fees – Index funds have fees that are often significantly lower than actively managed funds. This means that you get a bigger share of the returns.
- Index funds have better performance than active funds – There is ample research which shows that index funds have better performance specially in the long term. Many active funds may have better performance over specific periods of time but rarely they have better performance over long periods of time (e.g. 20 years). Index funds are not only cheaper but also better.
- You don’t have to do much – after you have picked a good index fund, all you have to do is keep buying it periodically (e.g. monthly/quarterly) and hold it for a long period of time (i.e. >10-15 years). You don’t have to research companies, read stock market news or monitor stock prices constantly. It is simple!
Investing in the stock market has some risks though. The stock market is highly volatile:
- Share prices can rise or fall 10% in a day
- During 2007 the market suffered a decline which lasted 17 months and lost 57% of its value. It took then 65 months for the market to recover to its previous peak.
Over the long term (> 10-15 years), the risks of loosing your capital are mitigated. The table below shows what we get if we calculate the long term returns all the periods of 10, 20, 30 and 40 years since 1928:
- The median annual returns for the periods over 10 years were above 6.5%
- The S&P 500 never experienced losses during any 20, 30 and 40 year period since 1928
- The S&P 500 still had a 4.3% annual return (after inflation) during the worst 30-year period since 1928
Savings accounts exist to preserve capital not to grow it. You can grow your capital by investing in low cost, globally diversified index funds.