Investing and Inflation

Time is Money – Inflation and the Future

There's one significant factor that we don't often consider when it comes to growing our wealth and that's time. The value of money is affected by many factors including inflation and exchange rates, but the one consistent rule is that money is worth more today than tomorrow.

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What is Inflation?

Inflation refers to the general rise in prices and fall in purchasing power in an economy. It's measured in Australia with the Consumer Price Index, which tracks the change in price of a collection of goods and services over time. The costs of individual goods and services are subject to a variety of influences, so this method allows for an average assessment rather than measuring, say,  the price of toilet paper which in recent times has shown remarkable volatility.

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Inflation and Purchasing Power

To get an idea of how inflation affects us, let's look at an example.

Next year I want to buy a new laptop computer for $2,000.  The Reserve Bank tells me that inflation is around 1.1% annually. This means that when I want to buy my computer in twelve months time it will actually cost:

$2,000 x 101.1% = $2,022

That's inconvenient, but not disastrous. But if we look at what our costs in retirement will be, that incremental increase when applied each year is going to make a much greater difference.

Let's say I calculate my future retirement needs, using today's costs, for electricity, food, transport and so on. I decide I'm going to need $500,000 to last me 20 years of retirement – around $25,000 a year.

If I want to retire with $500,000 in thirty years time at 1.1% inflation, I'm going to need $694,232.07 using the future value of money calculation, because all the essentials that are in my calculation will have risen in price each year, until the amount needed to cover them is much higher than it is now.

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Inflation vs Investment and “Real Interest”

To overcome this problem I can invest our money where it earns interest, which can offset or even reverse the effects of inflation.

If my money is in a savings account earning 0.4%, then the effect of inflation is reduced, which closes that gap between what I have and what I need, but it doesn't eliminate it. I'm going to end up with $563,613 – better, but still not enough.

In order to get an idea of whether we're gaining or losing against inflation we need to calculate the 'real interest' rate of our savings or investment.

Real interest = nominal interest rate – inflation

So my 0.4% savings account actually works out to be -0.7% (0.4 – 1.1 = -0.7).

To meet my retirement goal my investment return needs to be higher than the inflation rate, or the price of things I need will be rising and my retirement funds will not be keeping up.

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Staying in Front

Even if we don't worry about anything else, we must take into account the effect of inflation if we want to see long term growth of our purchasing potential. If our money is in a savings account and it's not earning at least as much interest as inflation, then we're actually getting poorer – the amount of money we have is the same, but we can buy less with it over time.

Time will either grow our wealth or erode it, and in order to stay in front, we need to take inflation into account.

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* The information provided in this article is general information only and does not take into account your objectives, financial situation or needs. Before making a financial decision, please assess the appropriateness of the information to your individual circumstances and consider seeking professional advice.

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