Inflation: CDs, a Shoe-Box or the Stock Market?

Tempted to stash
your money in a bank CD? Or maybe under your mattress or in a shoebox? Think
either one of them will keep pace with inflation? Think again.

Inflation

Inflation is
defined as an increase in the general level of prices for goods and services.
Deflation, on the other hand, is defined as a decrease in the general level of
prices for goods and services. If inflation is high, at say 10% – as it was in
the 1970s – then a loaf of bread that costs $1 this year will cost $1.10 the
next year.

Currently, the
inflation rate in the US is very high. Historically, inflation in the US has
averaged 3.3% from 1914 until the present time, but it reached an all-time high
of 23.7% in June 1920 and a record low of -15.8% in June 1921.

So how does
inflation affect your retirement savings? The answer is simple: inflation
decreases the purchasing power of your money in the future. Consider this: at
3% inflation, $100 today will be worth $67.30 in 20 years – a loss of 1/3 its
value. Said another way, that same $100 will only buy you $67.30 worth of goods
and services in 20 years. And in 35 years? Well, your $100 will be reduced to
just $34.44.

Bank CDs

A certificate of
deposit – a CD – is what’s known as a time deposit account – a bank agrees to
pay interest at a certain rate if savers deposit their cash for a set period of
time.

Generally speaking,
the interest rate paid by the bank increases as the term (the length of time
the bank has your money) increases. CDs are also insured by the Federal Deposit
Insurance Corporation for banks and by the National Credit Union Administration
for credit unions.

As the chart below
shows, CD yields have been in a steady decline for the past four decades:

Nearly 40 years ago, certificates of deposit were
considered really good investments, with the average annual percentage yield on
a one-year CD over 11%.

But today, although average rates on CDs are starting
to climb back up as the Fed has raised rates, the average one-year CD has an
APY of less than 1.50%.

The Stock Market

If you are looking for average stock market returns
over a long period of time, you are likely to get different numbers from
different sources. This is because your answer really depends on a number of
variables, including which index you review, whether dividends are included or
not, whether the effects of inflation are calculated, etc.

Most financial professionals would agree, however,
that the long-term data for the stock market points to an average annual return
of about 10%. In fact, the S&P 500 has returned a historic annualized
average return of 10.67% since its 1957 inception through 2022.

But it’s important to understand the impact that
inflation has on the stock market too – in other words, know that
inflation-adjusted returns on the stock market are typically 3-4 percentage
points lower than the long-term averages.

The Mattress and Shoe-Box

Surprisingly, we all
know people who prefer to keep their savings under a mattress or in a shoe box hidden away in a closet.

But here are the
Average Annual Returns for every investor who hid their money under a mattress
or in a shoe box:

What Investors Really Need
to Remember

Although there are times when buying a CD might be appropriate,
generally speaking, buying CDs should not be part of your long-term retirement
strategy – unless you happen to be very close to retirement age. CD rates today
just don’t keep pace with inflation. And putting your money under a mattress is
worse (and probably uncomfortable too).

Instead, I encourage you to explore the thousands of financial products
that provide better options. And remember that over long periods of time, the
stock market has outpaced inflation, today’s CD yields, and hiding your money
under your mattress or in a dark shoe box.

But before you invest in anything, consider the risk/reward tradeoff,
your goals, and your time horizon – be sure to talk to a professional about the options at your disposal.