Have you ever wondered how inflation affects your money? At first glance, it may sound like a great feature – your money is inflating. In fact, it does quite the opposite. But, there is an important first step to counteract its negative effects on your savings.
Money Under the Mattress?
My generation is two generations removed from the great depression and most likely more willing to invest money in investment opportunities that are not considered secure investments. I believe many have heard the stories of people stashing money under their bed mattress or in hidden areas. I know that I am almost always surprised by how much money some people can save by doing this. I just recently read a news article about a family buying a house, and when they were moving in they discovered a chest full of money. They had purchased the home from the children of a deceased father and the chest housed somewhere around $40,000 that this parent had stowed away over the course of his life. This sounds like a remarkable discovery and a lot of money. What a lot of us fail to consider is the adjustment of inflation or how much this amount of money could have amounted to if it had been invested properly.
I won’t go into some of the theories behind the cause(s) of inflation (nor can I personally understand them all). For our purposes of personal finance, it is sufficient to recognize that it exists. It is commonly accepted that the average inflation rate has been somewhere around 2-3% per year. What this means in essence is that a marketable good that would sell for $100 this year would sell at $102-$103 the next year. The price would continue to inflate with time. This means that the buying capability that you have with your money decreases over time. To give an extreme example, if you were to have $40,000 in the 1960’s you could buy more goods at that time than you could 50 years later. I have heard stories of families who bought their average-sized home for under $20,000. The same home sells for over $150,000 (if not more). What happens when you put your cold hard cash under your mattress? Let’s demonstrate with some simple calculations over a ten year period. If you were to put $100 of cash under your mattress for 10 years, how would inflation affect the buying capability of this money?
Are You Being Pushed Backwards?
Well, for each year, the value of goods would inflate at 2-3%. Let’s assume the inflation rate was an average of 2% over those ten years. This means that what you could buy for $100 at the beginning of this time would cost $122 at the end of the ten years. To understand this in how much of the original $100, it would be the same as having no inflation and losing $18 (100 / 122 = 82%; .82 x original 100 = 82). Imagine how you would feel if after 10 years, you discovered that bed bugs had eaten $18 of your original $100. This is what is almost guaranteed if you do not invest your money.
A helpful analogy to imagine the effect of inflation is that of a treadmill. Like the rate of inflation, the treadmill may change speeds. When it is moving, if you fail to walk in the opposite direction, you will be moving backwards. In order to gain ground (or money), you have to be moving forward. You not only have to move forward, but move at a faster rate than the treadmill is pushing you backward.
This is why investing is so important. By having your money in even a CD or savings account, you are gaining interest on the amount that you deposit. If you put the same $100 into a savings account that is paying you 2% interest each year (even this is hard to find at this time), you could counteract the effect of inflation.
The trick to earning money with your money (on top of inflation) is to invest in something that will give you a higher interest rate than the rate of inflation. There are many ways and forms to invest, but the first step is to start doing it! If you do not start now and you are letting your money sit under your mattress or in an account with .01% interest, you are already falling behind. It is important to be smart about how much you invest in unsecure investments, but the trick is to start now.
Below is a chart that helps illustrate the difference between keeping money under your mattress (green) and investing it, assuming a 6% return (purple). It covers a 30 year period for the starting value of $100. It also helps to see how your money compares to inflated prices (red), assuming a steady increase of 2%.