How inflation can reduce your savings and how to save money in such a way as to beat inflation.
Something that many savers don’t realise is that inflation (which I will explain in a second) has the ability to erode the money you are saving and in turn diminish its value – meaning your money becomes less valuable in terms of what it can buy you.
So before I go on to explain this in more detail and how people attempt to get around this, it is important to understand what exactly inflation is.
Inflation is the term given in economics to explain the rise in the general price of goods and services. This means that something as simple as a loaf of bread will generally change in price over the medium to long term. It may cost you only $3 today, though in 10 years’ time, the cost of a loaf of bread may indeed be much more – say $6 as an example.
So for someone who saves $3 today, in the hope of buying a loaf of bread in 10 years’ time – will indeed need to ensure that their $3 has the ability to earn enough interest or grow enough through investing to ensure it is turned into $6 within the 10 years, if not more. If the $3 does not grow in that time, you are effectively going backwards and your purchasing power is diminished to the point you cannot afford the bread anymore.
Apologies to those who might think of my example as a little too elementary, though economics is not something that needs any further complication.
So what does this mean for your savings?
It means that money you are saving for the future, whether it be in a high interest account or under your bed, needs to grow at a rate that is at least higher than the rate of inflation (if not significantly more) to help ensure the value of your money remains strong. Please note that the only thing that will grow on your money while stored under your bed is mould.
An example of how inflation could harm your savings
Say you invest $5,000 into a high interest savings account that earns you 4% p.a. If the rate of inflation is 3%, your actual return after inflation is accounted for is only 1%.
4% interest earned – 3% inflation = 1% actual return.
As you can see, the actual return is only 1%. This means your savings account that you opened because of the high interest rate, actually neglects the fact that your money isn’t in turn earning that amount because inflation is eroding its true value.
What do people do to try and beat inflation?
The end goal of many investors and money savers is to make their cash earn an actual rate of return which is higher than inflation and in turn helping them preserve their money and grow it.
A common way of attempting to beat inflation is by looking for ‘capital growth’ possibilities. This may take the form of investing in the share market, which means your money invested has the ability to earn you dividend income (depending on the shares you buy) plus capital growth from the price of the shares increasing (note that the shares can also decrease in price).
So say you invest that $5,000 in the share market with the advice of a financial planner. After one year, the company pays you a dividend of 4%. On top of this, the value of your shares has gone up via capital growth by 4% also (e.g. each share went up 4% from the purchase price you paid).
This means you receive 4% dividend income + 4% capital growth = 8% return. You then minus inflation, which we will say is 3% again and your new actual return is 5%.
This means that in the above scenario, the $5,000 was able to earn 4% more than straight up cash and effectively beat inflation and continue to grow the money invested above and beyond just 1%.
What is the downside of chasing capital growth?
While the above scenarios are completely fictitious, what you need to know about trying to achieve capital growth is that some years (for example post GFC) the share market can go down. This means the share price of the above company may actually go down and in turn provide zero capital growth (or negative capital growth) in that year. You also open yourself up to the ability to lose everything if the company were to head into financial trouble.
So what this means is that with the ability to earn capital growth, you open up your risk profile and take on more risk to chase a greater return. This is why financial planners are great at what they do, they can show you the pros and cons of each option – while still helping you diversify enough to ensure you sleep at night without worry.
The hardest thing about chasing capital growth is displayed in many financial advisors email taglines – that is, that ‘past performance is not an indication of future returns’ – meaning that the share market or any other investment for that matter, is completely at the mercy of the here and now and past performance should not be used as a way of making an investment decision.
Makes it tricky doesn’t it? It basically shows that investing in many ways is still simply a gamble to some extent.