Investing Made Simple - Part III: Inflation

It's been almost two months since the last installment in my "Investing Made Simple" series. In order to end the suspense which must be permeating cyberspace by now, I will unveil my third attempt to educate the masses in the art of investing. Today's article discusses the diabolical concept known as Inflation.

Simply put, inflation is the general increase in the cost of goods over time. It is measured by comparing the price of things at two points in time. The annual inflation rate is the percentage rise in the cost of goods over a one year period. For instance, let's say at beginning of the year a particular commodity cost $100. However, by the end of the year, that same item now costs $105. In this case, we can say that the annual inflation rate for that particular good is 5%, since it rose by that percentage over a one year period.

Obviously, different items will rise in price at different rates over a one year period. When economists calculate the annual inflation rate for the entire economy, they estimate it by examining the combined prices of a "market basket" of items. A "market basket" is a set of items that they feel that the average household will buy and consume over the course of a year. This includes food, clothing, gas, transportation, and so forth. Obviously, this is an approximation, but it does provide a useful view into how much prices are increasing.

The impact of inflation is that a dollar tomorrow is worth less than a dollar today.

This is a very important concept to understand when it comes to managing your money. What is means is that, over time, the value of the dollars in your wallet are eroding. Yes, a dollar is a dollar is a dollar, no matter how much time goes on. However, that dollar buys less and less every year. Consider that when I was a youngster, the price of a movie ticket was something like $5. Today, that same movie ticket is almost double that (moreso at some theathers!). When my father was a boy, that same movie was something like 25 cents (at least if you believe the stories that he tells!). It's not that dollars suddenly turn into quarters. It's that the world around them gets more and more expensive with each passing moment.

One of the goals of investment is to put those dollars to "work", in a manner of speaking, so that in the future they maintain their purchasing power. If things are getting more expensive at a rate of 3% per year, then unless your dollars are earning at least 3% interest, you are losing purchasing power. After a year, $100 worth of goods now costs $103, so if you have $100 today, then you will want to have $103 a year from now in order to make that same purchase. If you don't, then your $100 will be buying less than they were last year.

If 3% doesn't sound like a lot, then imagine what that 3% per year will be after 20 years. In the last installment of this series, I talked about the power of compound interest. Well compound interest can work against you when it comes to inflation. After a year, your $100 worth of goods now cost $103. After 10 years, it costs $134. After 20 years, it costs $181. If today you had $100 and you just stuck that money in a cookie jar, you'd still have $100, but because things cost more, you have lost money. On the other hand, if you invested that money at a modest 3% annual interest rate, you would have $181 so you can still buy the same market basket of goods.

In summary, inflation has the effect of eroding the value of your money. A dollar today is worth more than a dollar tomorrow. Therefore, unless your extra dollars are earning interest, you will find that the dollar sitting in your wallet will end up buying less than they did in the past.