How To Save Money Smartly
Historically, in some cultures, there is a tendency to associate the term savings with the idea of “keeping money under the mattress”. In fact, for the reasons we will see in this article, keeping one’s savings in one’s bank account can involve considerable losses. Saving has a different meaning if considered as a “stage” in a more complete process of managing and capitalising what you have.
What Does It Mean To Save Money?
Saving money is putting money aside for the future. To do this you need to be aware of our income and expenses. Only in this way can we put aside little by little money that makes us live more peacefully and, if we are smart, can give us the opportunity to retire earlier than we should.
However, the money we save constantly and in proportion to our income has value when it is put in a position to generate other value, i.e. other earnings. Ideally, we should invest some of the money we save in order to achieve returns.
Is It Worthwhile To Just Save Money?
Many of us prefer to deposit money in the bank with the promise of a fixed interest rate that can avoid constant worry. Unfortunately, following the crisis in 2008, the European Central Bank (ECB) interest rates plummeted to zero, eventually turning negative (around -0.5%). This had a direct impact on our savings.
1. We pay negative interest rates
The ECB sets the interbank interest rate which today, being negative, leads to losses for commercial banks. The commercial banks have to pay 0.5% on the reserves they deposit with the ECB. At this point, the negative rate should be reflected on their customers, but it is obvious that they cannot do so. After all, who would pay to freeze their money?
Therefore, banks still set the interest rate at a value higher than zero (around 0.37%). However, in order to protect themselves against losses, they are forced to raise commissions on individual banking transactions and services. In short, one way or another, negative interest rates weigh on the money we have deposited in the bank.
So the first reason why it is worth investing is to offset negative interest rates.
The interest rate is the percentage gain you get for “freezing” your money for a certain period of time. If I have an annual interest rate of 2% on my account and deposit 1000€, in one year this will become 1020€, with a profit of 20€.
2. Inflation erodes purchasing power
One of the reasons why you should invest is to protect your money from inflation.
Inflation is the general increase in the prices of goods and services over time, which leads to a general decrease in spending capacity. It follows that, with the same amount of money, fewer goods and services can be purchased.
Inflation causes our money to lose value over time. This is a natural mechanism for the progress of an economy like ours which is based on debt. We will devote more time to this, but the important thing to understand is that in a healthy economy things always tend to cost a little more over time.
Following this logic, the objective of European banks is to keep inflation at around 2% per annum to ensure virtuous growth in the economy. However, this objective is not always achieved and there are countries with higher or lower inflation, others that are in deflation.
As the chart below shows, the purchasing power of the Euro has collapsed since it has been in circulation (about 34%). This means that those who have not invested their capital since 2000 have destroyed more than 30% of their purchasing power.
Let’s take an example. An average purchase of various products worth 1,000 euros in the year 2000 would now be worth 1,347 euros. Going even further back in time, a purchase of 1000€ in 1980 would have cost 3.605€ in 2000.
Although necessary, inflation is ultimately detrimental to the money that remains in a bank account. Combined with negative interest rates, it erodes the purchasing power of money you don’t spend.
Saving is the First Step to Invest
So, in order not to suffer losses and make the most of what we earn, we need to approach savings only as the first phase of our financial management strategy. Savings allow us to generate a surplus that we can invest.
Whether we invest it on ourselves, on our education or in financial assets, it is money that has the potential to generate additional value. For example, investing money in a professional training course can help me to take up a better profession and thus earn a better salary.
Investing means turning savings into capital. An investment is an expense that is made with a view of a possible higher return. The greater the chance of profit, the greater the risk of loss.
Saving is necessary if we want to improve our financial situation. To begin with, we need to understand what our income and expenses are. On the other hand, saving to keep money in the bank is a harmful strategy in the long term, but it can be compensated for by investing part of these savings in assets or instruments that generate value over time.
Each instrument carries a higher or lower risk, which we will see in the next chapters. We, as human beings, also have a legacy of beliefs and behaviours that can hinder the results of our investments. Therefore, getting to know yourself will be one of the most important steps before taking up any investment method.