Why do we have to invest? Notâ€”newsflash!–to get rich quick or gamble. Job #1 is to preserve the purchasing power of money against the stealthy evil of inflation. When the cost of living increases, we say we have inflation.
If inflation is 3% a year, we need to find another three cents for every dollar just to stay in place. If we can invest in stocks of businesses that can raise prices with inflationâ€”not all canâ€”itâ€™s very possible that the stock prices will follow and protect us.
Even small inflation rates can really kill given enough time. If you bought something that cost a dollar at the creation of the Federal Reserve in December 1913â€”our third central bank systemâ€”it would cost you $23.61 today.
Or, if you had left that dollar under the mattress and your descendants found that dollar (gross!), it would buy four cents or 4% of what it snared back then. Yes, that may be 102 years, but you get the idea.
Inflation renders plain old numbers meaningless over time. A millionaire in 1913 really had some scratch. For the same purchasing power, Richie Rich would need $23,610,000 today.
A millionaire then is a millionaire now, but only in actual numbers, which we call the “nominalâ€ amount. The number that takes inflation into account is the “realâ€ or â€“ yes! â€“ inflation-adjusted number.
So why have inflation at all? The Federal Reserve prefers inflation to deflationâ€”falling pricesâ€”because deflation is horrific. If your dollar buys more tomorrow than today, why spend it? Money and the economy stop dead. This is why the Federal Reserve tries to tweak monetary policy to maintain inflation in the system, but just enough so no one really notices. If itâ€™s small enough, they think, no one will notice that itâ€™s a stealth tax.
Note that the “taxâ€ isnâ€™t the same for everyone. There is no single accurate number for inflation. If you have an off the grid house, inflation in the cost of electricity doesnâ€™t matter to you, nor do food prices if somehow you grow all your own food. But we all consume something where unless our income grows, rising prices hurt.
Nor is it always bad. Inflation helps borrowers at fixed rates. If your mortgage is a fixed 4% and inflation is 4%, your real interest rate is 0%. Free money! Not so good for the lender, who earns the same nominal interest rate but less real money if rates rise.
This is why in todayâ€™s low-inflation environment not all banks offer 30-year fixed rate mortgages and many prefer floating rates that rise with inflation. I didnâ€™t know this in the early 1980sâ€”it seemed just great to earn 10% on my money market account But inflation was as high as 18%. Oops.
We shouldnâ€™t be lulled into complacency by years of stable prices. We may be in a mildly deflationary environment today, but no one knows what will happen to whom, when, or where.
Yet you are ready. Whether we face deflation or inflation, get real. Letâ€™s understand the real, not nominal, progress of our money over time. The purpose of all investing at base is how to protect our money from inflation.
Tom Jacobs is a Big Bend-based Investment Advisor with Dallasâ€™s Echelon Investment Management. You may reach him at [email protected] and 432-386-0488.