Most personal financial plans fail by not asking the question, “What is inflation and how do I protect myself from it?” The purpose of this page is to define inflation, and how to incorporate into your financial plan.
A dollar today is always worth more than a dollar tomorrow.
This phrase which was drilled into our heads during economic class represents the true meaning of inflation.
Inflation can be defined two ways. First, its the increase in the average level of prices. Second, the decrease of your purchasing power.
The consumer price index, or CPI, is a monthly statistic released each month by the U.S.’s Department of Labor. CPI measures the average price for a basket of consumer goods purchased by the typical urban consumer. By no means perfect, this statistic is how the U.S. Government measures inflation.
The purpose of the CPI is to calculate the average cost of living today compared to a previous time. For example, if the CPI increased 3% in one year, $100 of goods a year ago, would have to be purchased for $103 this year.
Importance of Inflation
As an investor, it’s vital to understand and implement inflation protection into your personal financial plan. In 40 years, being a millionaire will have a different definition of what it is today. With a 3% inflation, $1,000,000 in 40 years is the equivalent of about $306,575. If you wanted to be the equivalent of a millionaire today, you would have to accumulate $3,262,037.
The easiest way to combat inflation is to start early, and invest regularly. By having a long-term horizon, you’re able to increase your risk. Therefore, increasing your reward. Over time, a broad diversification of stock mutual funds has outgunned inflation.
For shorter-term goals, there are many things you can do to combat inflation. Depending on the flexibility you can use CD’s and money market accounts as a way to protect yourself from inflation.
The worst thing you can do, is let your money sit in a low paying interest checking or savings accounts offered by most banks.
Compound interest can either be working for you or against you. Every year you delay, is one more day inflation gets to compound and your investments don’t.
Is Inflation Good or Bad?
Investors who understand and anticipate inflation can benefit from it. Let’s say you have a 30-year fixed mortgage, with a monthly payment of $1,000. Your payment next month will be $1,000, and your payment in 29 years and 11 months will still be $1,000. Since a dollar tomorrow will always be less then a dollar today, you benefit from inflation.
Where inflation causes the most pain, is when it’s not planned for. Let’s say you retire at 60, and have set aside $2,000 to live each month. If you didn’t plan for inflation, by the time you reach 90 your $2,000 will offer you less then half the purchasing power it once did.