The JumpStart Coalition is a national organization dedicated to teaching financial & economic literacy to educators. For 2013 their theme is savings and in July I'll be presenting my thoughts on this critical topic at their meeting being held at the Chicago Federal Reserve. What an incredibly simply, but profoundly important concept... savings. There is perhaps no more important a notion in building wealth and prosperity than savings, and yet there is nothing in the financial realm so difficult for people to actually incorporate into their life. The questions to be answered include; what is savings, why is it that people do and don't save, and what do we do with savings once it's been accumulated?
Let's look first at the question "what is savings and why is it so important?" Money at its core is the vehicle we use to allocate limited and scarce resources in an economy and to facilitate trade between goods and services. Most people are paid in cash so they don't have to grow their own food, make their own cars, or build their own houses... they can pay the money earned to the vendors of those goods who in turn use that money to buy the raw materials they need to produce their goods. Money is in that regard no more than an arbitrary means of exchange. But money serves another key function. It is also the primary vehicle for storing up accumulated wealth. In business, we call this "retained earnings", for people we call it "savings"; either way by not immediately consuming the money that is earned we are able to save it for future purposes. If you think about it (as I so frequently do) this saved money is in effect wealth! The ability to live in the future based upon your prior labor. This accumulated wealth serves many functions for people and for society as a whole, one of which is that it uniquely allows for a person who has stored up wealth to use that wealth to grow all by itself. In the case of the proverbial squirrel storing up nuts for winter, the purpose of the stored wealth is to provide the resource needed when productive work isn't feasible or possible. But unlike the squirrel storing wealth for near term consumption, we can use wealth to create more wealth; savings to create more savings. This is perhaps the one magic bullet of money; the ability to make a little of it create more of it. In finance, this is known as compounding.
Many of you have heard the famous question; if I were to offer you either a) $1,000,000 in cash, or $.01 and double each day for 30 days, which would you take? If you select option a), you walk out an instant millionaire - not a bad pay day. If however you took the penny, you have of course $.01 on day one, $.02 on day two, $.04 on day three etc. The temptation is certainly to take the $1mm. However, had you shown patience and a semblance of discipline, that $.01 at the end of 30 days isn't worth $1mm, it has grown to a whopping $5.3 million and if you're lucky and have a 31 day month, over $10.6 million! So a penny saved, can indeed be a penny earned.
Savings therefore becomes the base of your personal wealth; and as we scale up, it also becomes a community's wealth and a nation's wealth. Now rest assured that savings and wealth can be measured in ways other than just money; for example we can gain education, perspective and wisdom as we grow and that certainly has long-term benefit. But for most things, wealth can be most easily measured by money as a resource saved.
Now with this basic knowledge, knowing that basic savings a) measures our wealth and b) can take pennies and turn them into mega-dollars, why then do we face the dismal statistics we do related to American's lack of savings? Why do people not build robust savings accounts which can be used to provide for them in later unproductive years? I would make the argument that the first impediment to saving is ignorance and the second is apathy. Ignorance found in the lack of understanding of the importance of savings and how it can be used to enhance a person, a family's, or nation's future. And apathy which lies at the core of so many problems that leads to people simply not be concerned about their future; not caring because well, "out of sight, out of mind". It is a daunting challenge for educators to fight this ignorance and apathy in young people who by and large feel invincible and think they'll live forever. The problem with that of course is that people today will live longer than any previous generation; perhaps with new technologies as long as 100 years or more. But in the later years of their lives, they will not be as productive as they are in the earlier years and as a result will need to live off of the accumulated wealth they have; in other words, their savings.
If however a person is able to fight off the ignorance and apathy and begin building a savings account, the question of course is "what do you do with it?" In our example of the penny doubling, anyone would save that penny if they could simply double it each and every day, a 100% per day return. But that is not realistic of course. In reality, there are different things you can do (invest) with your saved money and an easy way to think of it is "asset classes". When you take your unspent money and leave it in the bank either in a checking or savings account, you are "investing" your savings in cash. Cash represents a short term, highly liquid asset class that generates relatively small returns but is very safe. As you move up the risk/return spectrum you encounter longer term "debt" investments called bonds, or longer term equity investments called stocks. There is of course Real Estate and other hard-asset investments and a wide range of synthetic (created) investments like mutual funds, ETF's and Options Contracts. And there is the time honored tradition of insurance and the tax benefits it offers. Knowing what each of these returns and how they fit into your portfolio is a function of knowledge and if appropriate for you, finding an advisor to help you.
As you consider investment returns, it's important to have a baseline expectation for what you can earn on your investments. Since 1950 for example, the U.S. stock market has grown by 11% per year whereas "cash" has grown by around 3.5% per year. So if you've been in the stock market, rather than doubling every day, you're doubling your money every 6 ½ yeas. If therefore an average American followed the simple rule to "pay themself first" and saved 10% of their gross income over their 40 year work life, the average American would have built a savings account of almost $1,000,000. So if we can educate American's on the importance of savings, we can build a nation of millionaires!