Chapter 5: Evaporation and Rainfall - Inflation and Unexpected Expenses

Weather can take a significant toll on a snowman’s longevity. Both the beating rays of the sun and the wear of drizzling rainfall can quickly shrink a snowman’s stature. The sun heats up the surface of the snowman, causing layers of glistening snow to slowly evaporate. The rainfall also heats up the snowman and drags bits of the exterior down to the snowy ground below. In both cases, there are ties that can be made between the well-being of a snowman and your savings.

Inflation

The evaporation caused by the sun’s unwavering heat causes the snowman to slowly shrink. A similar effect exists in personal finance, and it has the same results on the value of your savings. The term is inflation, and it means that year by year, the price you pay for the same goods and services increases. In other words, those fables of ten-cent ice cream cones and five-cent bags of candy you may have heard are in fact entirely true. Over time, prices increase, and the value of a loonie slowly shrinks.

Up until now, we’ve stressed the importance of getting to your money first and setting it aside for future expenses. We’ve also covered the risk and opportunity of investing your money to help it grow. But one very important and often overlooked component of savings is preparing for inflation. Let’s consider two cases to get an idea of how inflation works before continuing.

The Impact of Inflation

The first example of how inflation can impact your savings is an individual buying a new car. An eighteen-year-old walks into a dealership and finds his dream car with a price tag of $27,000. The teenager diligently sets aside money for five years and, on his twenty-third birthday, marches into the dealership with $27,000 in his account. To the young man’s horror, as he approaches the new car glistening in the sunlight, there’s an unfamiliar tag across its front windshield. The price of the car he’s been saving five years for is no longer $27,000 but instead $30,000. Over the past five years due to inflation, the cost of the same model car has increased by $3,000. Therefore, the savings he was able to set aside are unfortunately not enough.

While failing to account for inflation on your dream car would be heartbreaking, the impact is far greater when saving for a long-term goal, like retirement. Our next example is a couple that earns $85,000 a year after tax. They live quite comfortably while setting aside 15% for retirement and 10% for a down payment on a house. With the savings set aside, the couple can live happily off $63,750. It may stand to reason that the couple should be able to live off this same amount each year for the remainder of their lives. However, due to inflation, this isn’t the case.

The cost of paying for gas, buying groceries and all other expenses increases over time. The same goods and services the couple can buy with $63,750 today might cost closer to $127,500 when they retire in thirty-five years. If the couple only sets aside enough to spend $63,750 a year in their retirement, their standard of living would drastically decrease after cutting expenses to stay on budget.

Rate of Inflation

The average rate of inflation in Canada has been roughly 2% a year over the last forty years. While there’s no guarantee that individual expenses will follow this rate of inflation exactly, on average, the rate has been quite consistent. By planning for inflation on future expenses, you’ll ensure you have the money required to make the purchase.

Inflation is another reason why it’s very important that you’re putting your savings to work by earning a return. Money not earning a return by sitting in a chequing account decreases in value over time, like a snowman left out in the blazing sun.

Unexpected Expenses

With the beating sun accounted for, the second danger to a snowman is rainfall. If left uncovered in the rain, a snowman begins to melt away and once again shrinks in size. The equivalent to rainfall for your savings is an unexpected expense or loss of income. To protect yourself, it’s important to put savings aside in a separate account known as a “rainy day”—or emergency—fund.

As we previously saw, a critical step with high-risk investments is ensuring there’s enough time before you need the money. If you need to sell an investment early, it could result in large losses or additional fees. Because of this, it’s common to develop a buffer zone between unexpected events and your investments.

A Rainy Day Fund

To establish this buffer, it’s common to set aside enough money to cover your expenses for three to six months. It’s important to do this before starting to save for additional goals in case anything unexpected comes up. If your critical monthly expenses are $2,000, then it’s helpful to set aside between $6,000 and $12,000 before beginning to invest toward other goals.

The amount required depends on your current job security, the flexibility of your expenses and any insurance coverage you have. The more exposure you have to the damaging effects of lost income or unexpected expenses, the larger the buffer zone should be. Having readily available money for emergency situations is sure to bring peace of mind.

If you experienced a large expense or job loss without a rainy day fund, it wouldn’t be long before you’d be forced to sell your investments to pay for expenses. This could result in losses on what you’re selling. The rushed need to sell puts you at the mercy of what someone else will pay. By maintaining a rainy day fund, you can allow your investments the long timeframe they need.

Final Thoughts

As Canadians are aware, the elements can be harsh. While we’re most familiar with the challenges of cold, dark winters, we’ve now seen that rainfall and the sun’s beating rays can be equally menacing. It’s important to invest your money to offset the effects of inflation. In addition, setting up a rainy day fund will help with any unexpected events and allow you to save for your main goals with peace of mind.

Key Takeaways

• Your future goals will be more expensive than today due to inflation.

• It’s important to invest your money, so it’s not losing its value over time.

• Set up a rainy day fund with three to six months’ expenses to protect your other investments.

This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.