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Historical Significance of Capital Appreciation vs. Traditional Saving

Date : 29/09/2019

Author:  Abdulmohsen Al-Mudhaf

 

engage-chart.png
Data source: MorningStar, Jan 2008 to Jan 2018. Past performance is no guarantee of future results. 
*Please note slight overlap of Savings and Inflation lines.


Growing up, most individuals are conditioned to think under a certain umbrella of operations and actions. One that is fairly universal and familiar to us is the idea of saving which, as we will examine later on, carries with it a wide range of definitions. Conventional thinking adopts a low-risk, ‘sensible’ method of saving in its usage of commercial banking savings accounts. While this may be a fairly easy option for most, historical evidence may advocate for other means of appreciating collected savings and could point to a vast difference in both. The objective of this piece is to highlight both ideologies and, hopefully, set the scene for an argument that has existed since the dawn of the modern-day financial era. Moreover, when we examine the aforementioned methodologies for what they are and understand exactly how they satisfy certain related subgroups of the general population, we are able to then visualize the spectrum of risk appetites and see just how intricate that spectrum can get.

When we generally think about our ‘savings’, more often than not we are thinking about the money collected through time in our respective bank accounts (i.e. Checking and/or Savings account). The availability and increasing accessibility of commercial banking nowadays provides us with the opportunity to easily save our hard earned cash with no additional worry of lacking the financial knowledge needed to do so. Adding to that, should the individual choose to place his or her money into a savings account that accrues interest (i.e. fixed or compounding) over time, they are also getting the additional benefit of interest payments over time; or so they believe. Unfortunately, the economic climate pertaining to our financial world isn’t as black and white as we would like it to be. There are many crucial variables that must be accounted for when thinking about the long term effect of our savings. One of the more relevant variables to our equation is inflation and how it, unfortunately, has the potential to offset the interest payments collected over time through traditional savings accounts. For example, assume an individual in the US saves $10,000 at a fixed 2% compounded every year for 10 years. Assume also, that the average annual inflation rate is 2.1% (rounded average CPI from 2000-2018). The principal amount ($10,000) plus interest (2%) leaves that individual with $12,189.94 at the end of those 10 years. However, assuming a 2.1% inflation rate, the principal amount ($10,000) is now worth $12,309.98, so, in actuality, the individual has actually lost $120.04. This is a very basic example that skips over some of the more technical aspects of the concept, but the general message remains the same: inflation has the potential to offset interest gains from conventional saving.

The opposing side of this argument comes by way of capital appreciation in the financial markets. The process here is geared more towards investing (either self-invested or through an investment advisor) in financial securities and reaping the benefits through appreciation of the funds invested. One obvious downside to investing, however, is the susceptibility of exposure to all types of risks (i.e. market risk, liquidity risk, margin risk etc.). This is the main driver for the hesitancy that individuals exhibit when exploring such an option. Common practice and historical evidence have shown us otherwise, however, in that the use of sound investment practice has the capability of generating returns that far exceed those of the conventional saving model. Let’s revise our earlier example, but instead of investing the principal with a constant 2% annual rate, let’s assume the same individual instead invests the amount into an S&P500 ETF ($SPY) allowing for a broad US equity exposure. Let’s also assume that same individual invests at a peak right before the recession in 2008. This situation is contrary to what sound investment practices advise individuals to do. However, with that being said, the return on a less than ideal investment scenario, as our example illustrates, would still yield better results than our conventional savings example (within the same 10 year span). The amount an investor receives on a $10,000 investment placed on January 31st 2008 into an S&P500 ETF alone is $20,521.22  (including principal) on January 31st 2018.

 

Tags:  appreciation, Capital, savings

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