How Important Is It To Understand Inflation?

Tuesday, May 9th, 2017

Article By: David McDonald

Understanding Inflation is Crucial.

Everybody should understand the basics of inflation in order to form educated opinions on their country’s monetary and fiscal policies, as well as to properly invest their money so that they are bringing in returns greater than that of the inflation rate.

Let me explain,

Inflation is like this rat, it will slowly eat away at the purchasing power of each dollar in circulation. Everything in the economy ranging from goods to services will become more expensive overtime due to natural occurrences that cause inflation.

The thing about inflation however, is that wages and salaries rise more slowly than the prices of goods and services, making it difficult for many low-income earners to keep up financially.

So how can we use our understanding of inflation to benefit ourselves?

Say you are on of the three gentlemen in the picture above. The money being eaten by the rat is money that they have sunken into deprecatory goods/services. Any good that depreciates is one that loses value over time rather than gains value. We need to purchase deprecatory goods on a daily basis to survive however: food, water, gasoline, etc. But it’s the larger purchases that really affect us.

See, when you purchase a car for instance, the value of that car decreases each year.

On average, a new car will lose as much as 19 percent of its value in its first year of ownership. That means that your $20,000 new car will be worth about $16,200 after just one year. – Trusted Choice Home Page

But when you purchase a house for instance, this turns into an appreciatory investment.

The price of new homes increased by 5.4% annually from 1963 to 2008, on average. – Michael Bluejay – Official home page

Now, we can’t go about living life without purchasing things that depreciate, but we can be more conscious of our spending and saving habits, because it isn’t necessarily our incomes that will protect us from inflation – it is our knowledge of inflation, and the ability to choose sound investments to help protect our money in the long run.

Revisiting the previous image, we now see that the three gentlemen have purchased a house. The money being eaten away by inflation isn’t necessarily money thrown away; it could be used for groceries, electricity, gasoline, etc. But now, because they have a secure long term investment working for them, they aren’t nearly as affected by inflation as they were before.

This is the simplest way I can answer your question: The most important part of understanding inflation is to know how to invest your savings in a such a way that you will be earning more than the rate of inflation on income other than your salary.

Okay, that was a bit wordy, let me try again.

You can’t rely on just your salary to protect you from inflation – you need to save and invest your earnings on the side so that you can make bigger purchases that will keep your assets going up and not down.

But here’s the tricky part; just saving your money isn’t enough.

You can put your money in fancy RRSP’s or TFSA’s and see little to no results.

Here’s an ad on Google. You indeed have to be high to call a 1.3% interest rate return, “high” Because inflation tends to run at around 1–3%. The Bank of Canada, for example, has had their target inflation rate set at 1–3% since 1991.

To explain more clearly; if your savings are earning 1.3% and inflation is at 2%, you aren’t making any money, and this is not a good investment.

That is why it is imperative to understand inflation when investing – those who don’t, will think an investment like this is going to make them a lot of money in the long run, when in reality, it won’t even make a dent.

Now that you understand inflation, and you know that saving your money at 1.3% interest isn’t going to do jack, so what do you do?

Well, I would suggest incorporating a little risk into your investment portfolio.

There are three main types of Investment: Ownership, Lending, and Cash Equivalents

Ownership Investments

Ownership investments are what comes to mind for most people when the word “investment” is batted around. Ownership investments are the most volatile and profitable class of investment.

Examples of an ownership investment include:

Stocks

Stocks are basically certificates that say you own a portion of a company. Your expectation of profit is realized (or not) by how the market values the asset you own the rights to. If you own shares in Sony and Sony posts a record profit, other investors are going to want Sony shares too. Their demand for shares drives up the price, increasing your profit if you choose to sell the shares.

You can make the most money off of stocks, but it takes a lot of research in not only the companies that you want to invest in, but in the market as a whole. On top of that, the stock market is volatile; no amount of training, expertise, and preparation for a trade will guarantee success, however, if you have more winners than losers in the long run, you can accumulate a decent sum of wealth which can help with a downpayment for a house in the future; an investment which is almost sure to appreciate.

Business

The money put into starting and running a business is an investment. Entrepreneurship is one of the hardest investments to make because it requires more than just money. Consequently, it is also an ownership investment with extremely large potential returns. By creating a product or service and selling it to people who want it, entrepreneurs can make huge personal fortunes. Bill Gates, founder of Microsoft and one of the world’s richest men, is a prime example.

Real Estate

Houses, apartments or other dwellings that you buy to rent out or repair and resell are investments. The house you live in, however, is a different matter because it is filling a basic need. The house you live in fills your need for shelter and, although it may appreciate over time, it shouldn’t be purchased with an expectation of profit. The mortgage meltdown of 2008 and the underwater mortgages it produced are a good illustration of the dangers in considering your primary residence an investment.

Precious Objects

Gold, Da Vinci paintings and a signed LeBron James jersey can all be considered an ownership investment – provided that these are objects that are bought with the intention of reselling them for a profit. Precious metals and collectibles are not necessarily a good investment for a number of reasons, but they can be classified as an investment nonetheless. Like a house, they have a risk of physical depreciation (damage) and require upkeep and storage costs that cut into eventual profits.

Lending Investments

Lending investments allow you to be the bank. They tend to be lower risk than ownership investments and return less as a result. A bond issued by a company will pay a set amount over a certain period, while during the same period the stock of a company can double or triple in value, paying far more than a bond – or it can lose heavily and go bankrupt, in which case bond holders usually still get their money and the stockholder often gets nothing.

Your Savings Account

Even if you have nothing but a regular savings account, you can call yourself an investor. You are essentially lending money to the bank, which it will dole out in the form of loans. The return is pitiful, but the risk is also next to nil because of the Federal Deposit Insurance Corporation (FDIC).

Bonds

Bond is a catchall category for a wide variety of investments from Treasuries and international debt issues to corporate junk bonds and credit default swaps (CDS). The risks and returns vary widely between the different types of bonds, but overall, lending investments pose a lower risk and provide a lower return than ownership investments.

Cash Equivalents

These are investments that are “as good as cash,” which means they’re easy to convert back into cash.

Money Market Funds

With money market funds, the return is very small, 1% to 2%, and the risks are also small. Although money market funds have “broken the buck” in recent memory, it is rare enough to be considered a black swan event. Money market funds are also more liquid than other investments, meaning you can write checks out of money market accounts just as you would with a checking account.

Close, but Not Quite

Your education is called an investment and many times, it does help you earn a higher income. A case could be made for you “selling” your education like a small business service in return for income like an ownership investment.

The reason it’s not technically an investment is a practical one. For the sake of clarity, we need to avoid the ad absurdity of having everything be classified as an investment. We’d be “investing” every time we bought an item that could potentially make us more productive, such as investing in a stress ball to squeeze or a cup of coffee to wake you up. It is the attempt to stretch the meaning of investment to purchases, rather than education, which has obscured the meaning.

Not Investments

Consumer purchases – beds, cars, TVs and anything that naturally depreciates with use and time – are not investments. As an example, you don’t invest in a good night’s sleep by buying a foam pillow. Unless you’re very famous, and even then, it’s a stretch, since you can’t reasonably expect someone to pay more for your pillow than the initial purchase cost. Don’t take it personally, but there’s very little demand in the second-hand pillow market.

The Bottom Line

Admittedly, it’s a clever piece of advertising that removes some of the guilt from impulse purchasing; you’re not spending money frivolously, you’re investing! The decisive test is whether there is a potential to turn a profit. The important word is “potential” because not every legitimate investment makes money.

Making money through investing requires researching and evaluating different investments, not simply knowing what is and is not an investment. That said, being able to see the difference between an investment and a purchase is an essential first step.

Furthermore, being able to understand inflation and how it will influence your spending habits and earning potential will be a deal-breaker in terms of you being able to accumulate steady long term income aside from your salary.