One of the concepts which we all need to be acutely aware of when it comes to managing our finances is inflation. Inflation is that silent killer that over long periods of time can have a very detrimental impact on our net worth. So much so, that we need to constantly be fighting against its destructive forces.
What is inflation?
I am not a trained economist, and this is a really complex concept. I will do my best to explain the causes of inflation, but don’t hold me to it. In essence, money becomes worth less over time. $1 today is not the same as $1 last year, nor is it the same as $1 in a year from now. Governments attempt to hold inflation to a 2% rate each year, meaning that each year, the spending power of $1 reduces by 2%. Inputs into the calculation of inflation are the supply of money in an economy, how that money is being held/spent and the value of goods and services being produced by that economy.
Here’s how I look at it. If a country’s economy produces $100 billion a year of gross domestic product (GDP), but the government prints another $200 billion of money into circulation, then there is more money to go around to buy the same stuff, resulting in the ability to charge more for those goods. What used to cost $1, now costs $1.05. The economy needs to grow commensurate with the supply of money for prices to remain stable.
This is why it makes me, and so many others, nervous when governments are printing trillions and trillions of dollars to keep the bottom of the economy from falling out during Covid. Unless the government reduces the money supply later on, or the economy rises in size significantly, inflation would seem to be in the cards. There are other factors of course, like technology, that can counter inflation by allowing goods and services to be produced for less money, causing deflation.
What you need to know is that inflation is usually around 2-3% per year.
What does inflation do to assets?
Every year, your assets’ value decreases by inflation, whether you like it or not. $100 in a bank account this year can buy $100 of goods. Next year, after a year of inflation has taken place, your $100 buys $98 of goods in “real” terms. The next year, $96. In essence, prices are going up every year by 2%, and your $100 buys less and less every year.
This is why in my opinion, any investment that yields anything below inflation is destructive to your net worth. Holding cash, for example, which produces less than 1% interest each year, is actually resulting in your net worth DECREASING in value. You get 0.1% interest from the bank, but inflation reduces the value of your cash by 2%, so your bank account produces a -1.9% return each year. This is why I hold virtually no cash. There are other liquid ways to keep dry powder. Do you see now why cryptocurrencies like Bitcoin are just crushing it right now? People don’t trust that the USD will hold its value and they don’t trust that the US government won’t continue to print more. Printing money is actually a hidden tax on people – it taxes them by making their money worth less, just as if they had paid more tax to the government.
The same goes for mutual funds. If your mutual fund has an expected return of 7%, you are really earning 5%. Oh right – don’t forget your management fees to the fund manager of 2%. You’re really only earning 3% on your 7% mutual fund. Less than HALF of what the mutual fund info sheet tells you to expect. These calculations are important aren’t they?
So what can you do!?
Invest in things which produce a yield, after inflation and management fees, that gives you enough “real” growth to meet your financial goals. Good places to start are low cost ETF’s that have Management Expense Ratio’s next to zero and just track passive indices. It means you have to be on the hunt for returns.
Yes, this means risk. You can’t grow a sizeable net worth after inflation without taking on some risk. The S&P 500 index has yielded 10% or so since the beginning of time. Real Estate investments produce 4-6% yield, into the teens easily when levered with debt. These are the kinds of investments you have to consider if you want to retire early and gain financial freedom. It simply isn’t possible with savings accounts, money market securities, government bonds and other forms of low risk investments. If you don’t have the appetite for risk, that needs to factor into your expectations for your financial future and lifestyle.
You also need to make sure your income is growing at a pace faster than inflation each year so that you can keep up with the growth in prices of the day to day things you buy like groceries, transportation, housing and consumer goods. All of these things are subject to the impacts of inflation. This is why your grand parents could buy a hot dog for $0.20 in the 1940s and it costs you $3. I’m sure one day your grandkids will be shocked at the $3 price because hot dogs 80 years from now will likely be $15. Income growth in the US is not keeping pace with inflation, so hustle and earn those raises. It’s the only way to get ahead.
Keep inflation in mind for typically-held-in-cash pots of money like emergency funds . Six months salary decreasing by inflation over your whole career has a pretty massive opportunity cost. Think about other strategies like using an undrawn line of credit as an emergency fund, and putting the six months salary you’d otherwise hold in cash into an index fund. You won’t qualify on the line of credit until you have solid income and assets anyways. I would way rather get the compounding impact of 7-8% returns on my investments with the risk of paying some interest between jobs, than sacrificing that growth to hold an asset which DECREASES IN VALUE GUARANTEED!
Does inflation impact debt?
Yes! Inflation has the equal and opposite impact on debt that it does on assets. It makes the debt EASIER to pay off over time. The amortization of a mortgage or investment loan is fixed on day one. The payments are mapped out for the 25-30 year period. So doesn’t inflation mean that the last payment in year 30 is 60% easier to pay that the first payment (2% * 30 years) ? Yes!
This is why I like to include a portion of levered investments in my portfolio, especially real estate. Inflation causes real estate to appreciate, and it causes the associated debt to reduce in real value. Debt can be your friend if you can service it with passive cash flows while you wait for the asset you bought with it to appreciate.
The Bottom Line
Inflation is real. It is eating away at your assets everyday. You need to beat it by growing your net assets by at least 2-3% each year to just keep up with it. Have a sense of urgency on this. It can have a profound impact on your net worth over long periods of time.