The last investment blog talked about “Why Invest?” and I told you it was because of the power of compounding and that is a great reason why you should invest. Here is the reason why you must invest: Inflation.
Excerpt from The Graduate’s Guide to Money:
Inflation is the rise in prices over time, typically with regard to consumer goods, food, and the like. Back in the 1970s, gas cost 35 cents per gallon (hard to believe). Today, one gallon of gas is easily closer to $3 per gallon. Compare the cost of most any other item or service from 40 years ago with the cost today, and you’ll see how inflation plays a part in every aspect of life over time. This is called purchasing power. Think if I had put 100 10 cent stamps in my drawer back in 1974 so that I could mail 100 letters in 2015. Whoops, I can actually only mail about 50 letters since postage is now 49 cents per letter. The same thing happens with your money sitting in a drawer or a bank – it just won’t buy as much 40 years later as it buys today.
You need to keep your purchasing power the same in the future (at financial independence) as it is today. To do this, you have to invest your savings such that those dollars at least maintain their purchasing power over time. This gives you the opportunity to buy the same goods and services with those dollars in the future that you can buy today.
The bottom line is that you cannot bury your money in the backyard nor put it in a low-interest savings account and wake up in 40 years thinking that you can live the same lifestyle that you live today. That’s why you must invest your money.
The price of goods is impacted by not only inflation, but also by supply and demand, the political climate (especially around gas), the economy in general, and how it impacts employment, among many other factors. Economists track inflation by defining a “basket of goods,” and every year, they “go shopping.” for this same basket of goods and see how much it costs. That gets compared to the prior year so they can calculate the change in the Consumer Price Index (CPI), a common way to measure inflation.
The compounding of inflation over time erodes the purchasing power of a dollar. To combat that, you must earn more than inflation every year so that your interest compounding beats the inflation compounding. That’s another reason why you must invest—to beat inflation. You also hope to grow your assets, obviously, but you must grow them enough to cover inflation first and then to get additional purchasing power.
If you look at inflation rates in the last decade, it has been as high as 4.4% (2007) and as low as .1% (12 months ended 6/30/15). We typically peg inflation at an average of about 2.5% to 3.5% per year when we do projections but the bottom line is that your money has to be invested to at least earn in that range over time to keep with up raising costs.
So, that’s why you invest – for its power through compounding and its necessity to keep ahead of inflation. Up next time – How to Invest.
To your financial success!