Inflation can sap the value right out of funds held in banks. Still, it's vital to have adequate short-term savings to carry you through emergencies. We've opened a short-term savings center to help plan your savings. One option is the I Bond, which provides inflation protection and tax-deferred savings with decent liquidity.
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Warning! If you have money in a checking account, you are probably losing money every year, even if it earns you a modest interest rate. Slowly but surely, its value is eroding. If you maintain a high balance, you're losing a lot of money. It's that ol' monster Inflation that's eating away at your savings. A lot of us forgot about inflation there for a while, as it dipped down into the low 2% region. We didn't feel it very much in our daily lives. But it was there, quietly eating, and waiting for the opportunity to binge on our savings. And you never know when it will attack again. You may feel confident that the Federal Reserve and its shining knight, Alan Greenspan, will keep Inflation ever at bay. Don't be so sure. In the 1970s, inflation ran at a 7.8% rate annually. In the '80s it fell to 4.75%, but even that rate will kill off almost any checking or savings account. The '90s saw inflation fall to 2.82% annually, but it's run about 3.55% so far in the '00s. That beast will never die. It will ravage the land again one day. The importance of short-term savings Well, yes, long-term savings have historically been best off in the market. Most of you have gotten that message (though too few of you are maxing out your Individual Retirement Accounts -- get right on that). But we have also repeatedly stressed the importance of maintaining short-term savings as well, and that is where Americans seem to have trouble keeping up. Lots of people fund their 401(k)s, but very few actually have six months of savings sitting in liquid investments in case of emergency. It is this fact that has caused the nation's bankruptcy rate to skyrocket, not lack of savings. People take out what seems like reasonable student and car loans, and then add a dash of credit card debt (hey, everybody's doing it). Then along comes something -- a child, a layoff, or a disability -- and boom, just like that, they're in over their heads. It is for just such people that we recently launched a new short-term savings center. We discuss why you need short-term savings, how to calculate your personalized savings needs, and what short-term investments are available to you. Through our partners, you can even get a special rate on some certificates of deposits and money market accounts. Where to invest for the short-term Often we just never get around to doing anything with that money. I confess that I myself have left my short-term savings in a less-than-ideal place for some time now. But I'm doing something about it. I'm trying to keep my savings liquid -- that is, easily convertible into cash-on-hand -- but I'm willing to take a small liquidity risk. I'm buying an inflation-indexed bond, or I Bond, with half of my emergency savings. The I Bond The advantages of the I Bond extend beyond their inflation protection. The main disadvantage of the I Bond is its relative illiquidity, but even that's not too bad. I have to hold it for six months after the issue date to get the original investment plus the earnings, but I can sell it anytime thereafter. If I redeem it within the first five years, there is a 3-month earnings penalty. So if I redeem my I Bond after 18 months, I'll get 15 months of earnings. Be prepared for inflation Brian Lund, if this wasn't clear, fears nothing more than inflation. Well, he's pretty scared of clowns, too. He doesn't own the Federal Government or any I Bonds -- yet. The Motley Fool is investors writing for investors.
Lots of you may not care about inflation. You've got your savings in the market, and you figure you'll handily beat inflation over time, as stocks historically have. Cash is for losers.
That last point is very important. You may build up short-term savings in a checking or savings account, only to see it ravaged by that bête noire inflation. Short-term savings need allocation too. If you're really putting six months' living expenses aside, it's a decent amount of coin that may well go unused, if no emergency emerges. From a cash flow perspective, it's fairly stagnant.
An I Bond has two separate rates: a fixed rate of return and a variable semiannual inflation rate. The fixed rate remains the same throughout the life of the I Bond, while the semiannual inflation rate can vary every six months. For example, the fixed rate may be 3% when I buy it -- that's permanent. On top of that, the Fed will affix an additional return equal to the Consumer Price Index-measured inflation rate -- right now, about 3%. In total, it earns about 6% right now. If inflation goes up, however, my return goes up accordingly. If deflation occurs, meaning that cash gains value, the variable rate can bring the total return down to 0%, but not below it. This gives some downside protection in a dreadful deflationary environment.
That's a bit of an annoyance, but even if an emergency happens and I have to cash out early, I'll still make a decent profit. Most of all, I'll be protected from the vagaries of inflation. Small investors have generally not sought inflation protection through inflation-indexed securities and I Bonds because the threat of inflation has appeared to dwindle in the recent past. Remember, the beast will rear its ugly head again. But you can beat it.
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