What is inflation and why it matters to your investments

 

You’re probably familiar with inflation…right?

You may be surprised. According to recent results from the HILDA survey only 77% of men and 63% of women correctly identified the concept of inflation. Moreover, there’s a difference between knowing what inflation is, and knowing the impact it has on your investments.

‘Inflation is taxation without legislation.’
 – Milton Friedman

What is inflation?

Inflation is the rate (typically measured over a year) at which goods and services increase in value and the corresponding decrease in the rate of the purchasing power of currency.

Let’s look at a simple example. Say you bought a flat white coffee at the local cafe for $4.00. We’ll assume the annual inflation rate for all goods and services is 2%. This means that for every dollar, the average price of everything will increase by $0.02 because ($1.00 x 2% = $0.02). So exactly one year later, you’d have to pay (($0.02 x 4) + $4.00) = $4.08 for that same latte.

Easy to understand right? But the consequence of inflation isn’t just that the price of coffee went up – it’s that the purchasing power of your money also went down. If the price of everything goes up by 2% then a dollar won’t be worth a dollar in one year – it’ll be worth ($1.00 – $0.02) = $0.98

Wait, my money becomes less valuable over time?

If your money doesn’t grow at a rate of return equal to or faster than the rate of inflation, then yes.

Say you deposit your money into an high interest savings account (HISA) with a 2% p.a. interest rate. That means your savings will grow at a rate of 2% every year.

But, over that same year your money will also decrease in value due to inflation. If the inflation rate is 2%, then after one year your money would be worth essentially the same. This is because the rate of inflation wipes out your gains from interest (2% interest rate – 2% inflation rate )= 0% rate of return.

And that’s before any taxes you’d pay on your interest – if you include taxes then you’d likely be losing money every year! That’s why HISA are OK for short-term goals, but if you’re looking to grow your money over a longer time horizon then you may want to consider other investment vehicles like Clover.

How are investments affected by inflation?

Inflation essentially eats into your returns, so it’s important that your investments have a rate of return that’s (ideally) greater than the inflation rate.

Another simple example. Let’s say your investments are currently earning an average rate of return of 7%. If inflation is 2%, then your investments would be growing at (7% – 2%) = 5% every year (excluding taxes and other fees). So you’d likely be coming out ahead as your rate of return would be greater than the rate of inflation.

If money declines in value every year and stuff gets more expensive, then how does anyone afford to buy anything?

Because (in theory) your income will also increase every year. Salaries are suppposed to increase at a rate comparable to the inflation rate. So if the inflation rate is 2% every year and you get a 2% increase in pay every year then you’re ok – because the buying power of your dollar remains constant.

But I haven’t gotten a 2% raise in a long time? Does this mean that I’m actually able to buy less with my salary?!

That’s exactly right – in our most recent white paper we talk about how wage growth in Australia is stagnant.

What if inflation gets really high?

That’s called hyperinflation and it’s really bad news. It means that stuff increases in value so quickly and the purchasing power of currency declines so rapidly that people can’t adjust. The result is a big gap between what people earn and what they can buy. If you want to see how bad it can get check out what’s happening in Venezuela – where inflation is currently on target for 1,000,000% (yes, you read that correctly)!

That’s why it’s important for countries to keep inflation under control. Most developed countries (like Australia) aim to keep inflation between 2 – 3%.

Do we need inflation?

That’s a very good question and one deserving of a more detailed response than this post. Many economists believe that stable inflation is necessary to increase consumption – with the belief that higher levels of spending are good for the economy. But not everyone agrees – some economists believe inflation can be a drag on economic growth. It’s a matter of debate among economists, politicians and businessmen.

A final note

Remember that inflation doesn’t just impact the price of goods and services. Always consider how inflation will reduce the rate of return on your investments. It’s a significant factor that can often be overlooked by many new investors.

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