Written by Andrew Cassar Overend
9 min read
Last Updated on July 31, 2021
In 2020, around 38% of Americans could not fork out $500 to finance an emergency without taking on debt. ^1 41% of UK residents did not have sufficient savings to live for a month without income and 9% of UK residents have no savings at all. ^2
These statistics imply that a significant number of people do not have enough savings, so the fact that you are pondering on whether it is possible to have too much savings probably means that you have a decent amount saved up - kudos to you for saving this much.
But is it even possible to have too much savings? It actually is, and it depends on both systemic factors, such as the real interest rate, as well as idiosyncratic factors such as your liquidity requirements, your age and your goals.
Savings are what remain from your disposable income after you've satisfied your spending requirements. It is the riskless practice of setting money aside to preserve its liquidity and with no intention to increase its value. Think of savings as money deposited at the bank such as demand deposits, time-deposits or even short to medium fixed-term accounts. The low interest rate environment over the past decade has made compounding savings impossible.
Savings differs from investment, the latter being a deliberate decision to compound money by taking on some risk and forgoing liquidity.
While having some money set aside as savings is always plausible, holding excessive savings creates what economists refer to as an opportunity cost. This is because these excess savings could have been invested to earn a higher return.
This article focuses on when holding excessive savings is not ideal. Let’s get into it.
Your age, the interest rate on savings, and the goals you plan to achieve collectively determine whether you are oversaving or not.
The nominal interest rate is the reward for saving.
Most people think that the primary function of banks is to hold our savings. But in truth, by depositing our savings in the bank, we are loaning the bank our money. This interest received on deposits is the reward the bank gives us for lending them the money, which they use to make further loans or buy return-generating assets like bonds.
With interest rates on savings at zero we're essentially loaning out our money to banks for free. Actually, when accounting for withholding taxes, inflation and the creative fees banks come up with for nothing, we are being charged for keeping money at the bank. This fact alone should set off the alarm bells!
Adjusting the nominal interest rate for inflation, we get the real interest rate.
Whenever inflation exceeds the nominal interest rate earned on your savings, the purchasing power of your savings erodes. Therefore, in a low or negative real interest rate environment, the opportunity cost of saving is high, because investing the money would yield a higher return.
By saving too much you will be forgoing the opportunity to accelerate these savings by investing in appreciating assets, such as real estate or equities, or make productive use of the money like starting a business. It is useless parking money in a low-yielding bank savings account when you could be compounding your wealth instead.
Takeaway 1: When the real interest rate is low or negative, then you should avoid maintaining a high savings balance and maximize the potential of your savings by investing.
Basic financial management requires that you keep 3 to 6 months equivalent of your wage as precautionary saving. After setting aside emergency fund requirements, you should be thinking about your medium and long term goals. In doing so, you will establish how much liquid savings you need to meet your purchasing requirements.
To illustrate, consider saver Sally who has £15,000 set aside in savings, £9,000 of which will be used to purchase a car in three months’ time. Sally has monthly average expenditure of £2,000. After reading Financial Fortify's article on how to manage money, Sally set aside 3 months’ worth of her spending (£6,000) in an emergency fund. This means that now Sally has £9,000 (£15,000 - £6,000) remaining in savings. Does it make sense to invest this money? Not necessarily, because this capital would be required in three months’ time to purchase the £9,000 car. It would thus make sense to retain the £9,000 in a liquid form of savings.
So in this case, Sally did well not to invest the remaining £9,000. However, had she not needed the car, these £9,000 could have been easily invested to let compounding do its work. Parking more money than you need to secure your emergency fund and achieve your goals in a savings account comes with a high opportunity cost.
Takeaway 2: The amount of savings you should keep liquid depends on your short term spending requirements and medium term goals.
The propensity to save is partially determined by age and social status.
Younger people tend to have lower incomes than those who are middle aged. They are also likely to consume a higher percentage of their incomes, because they undertake initial capital purchases (such as cars, laptops, furniture), whilst also spending more on recreational consumption (clubs, games, events).
Every individual's financial and socio-economic situation merits its own consideration, so it is not right to generalize. If, for instance, you are deep in debt, or you have ambitious goals to reach (such as early retirement), then abstaining from spending in the present may be the only option. Moreover, if you are in a relationship and have kids, it is financially prudent to keep more money in savings.
But if you feel guilty when spending to enjoy yourself in spite of having a stable inflow of income, a good financial position, and a decent investment portfolio which is able to compound sufficiently to get you through retirement, then you might need to loosen up a notch. Think of the experiences, opportunities, and memories which you may miss because of your urge to save. Ultimately, the best time to spend on new activities and experiences is when you are young.
Consider the case of pensioner Pete who has accumulated a decent retirement pot from past savings. Does it make sense for Pete to continue saving throughout retirement? Pete may still have saving goals like leaving income for his kids and grandkids, but unless he has strong beliefs that an Egyptian afterlife exists, then it would not be rational for Pete to be excessively frugal.
That said, many elderly individuals spend most of their retirement worrying that the combination of their lifetime savings and the state pension they receive will not be enough to get them through retirement, especially as life expectancy continues to improve.
However, the abstention to spend may hinder them from enjoying their hard earned retirement. This is why it is crucial to start investing from a young age and make sure you educate yourself financially. On that note, do join the Financial Fortify community, since our mission is to pave the way for your secure financial future!
Takeaway 3: Savings also depends on your age. When you are young, you are likely to have less capital to save, but you can adopt a more aggressive investing approach. As you age, your capital should increase, but you should allocate a higher proportion of your wealth to safer investments or savings.
So maybe you’ve realized that you have too much savings after considering your spending requirements, goals and age. What now?
Well, firstly commend yourself once again for being where you are. Your finances are certainly in a better position than those of most people. But now it’s time to see how you can turn those unproductive savings into something with more value.
Assuming that you’ve already secured your short-term emergency fund, you should determine your medium and long term goals and work backwards to determine how much you need to invest to reach these goals in the timeframe you prefer.
For instance, if a medium-term goal of yours is to buy a car, then set up a fixed-term savings account specifically for that, and deposit the desired amount from your accumulated savings into that account. Similarly, for your long-term retirement goal, set up an investment account with a bank or broker specifically for retirement and invest some of the accumulated savings in that account, and be sure to commit to do so regularly.
But not everyone has the same appetite for risk. Some people simply cannot stomach investment risk or think that investing is something beyond them, so they prefer to keep their savings at the bank. If you are one of those people, we've got your back. In the coming weeks, we'll be launching a step-by-step guide to start investing. We encourage you to sign up to get notified when it is released.
Many people mistakenly think that investing is only done in stocks. But in truth there exists a diverse set of asset classes you may choose to explore. If investing in risky financial instruments like equities is not for you, then why not consider safer options like bonds? Or if intangible financial instruments are not your cup of tea, why not invest in tangible assets like real estate, art, wine or watches?
Once you’ve set aside the appropriate monthly amount to ensure you achieve your financial goals, you can use your remaining income to explore spending on goods or services which provide you with value, such as going on holiday with your loved ones, taking a University course or buying a luxury vehicle. If you cannot think of anything to do with your excess savings, then why not give some of your savings to charity? That would be one noble gesture.
In today's screwed up financial system, investing is imperative to guarantee your future financial prosperity! By saving, you're simply hoarding a devaluing currency, and your financial goals will become extremely hard to attain, given that banks are paying you nothing when you lend them your money.
Another overlooked determinant of peoples’ saving is their time preference. Those who attach a higher value to their future situation are likely to save more. If you are one of these people, then you are willing to work harder today to be better off in the future.
Setting ambitious goals is a good thing, but by working endlessly to achieve them you risk getting burned out. If you are always working, constantly planning and thinking about the future, then your life will pass by before you know it. When working long hours feels 'normal' or when you find yourself trying to keep up with more than one job, then you may be living to work rather than working to live.
That said, if you’re struggling to make ends meet, the ideal option would be to: 1. Change jobs. Switching jobs often results into a significantly higher pay, and 2. Create different sources of income. Stay tuned for our upcoming article about how to create multiple sources of income.
This will allow you to set some money aside each month to achieve your goals, without compromising your health and your relationships. We often take for granted the fact that we have limited time in this world. Therefore, aside from our finances, we should invest our time in things which provide us with everlasting value, like education, relationships and unforgettable experiences.
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