by David Berky
"Inflation is the overall or
specific increase in the cost of a good or service."
Thank you, Mr. Dictionary.
Inflation is when your mom or dad complains about
the prices they have to pay nowadays compared to what
they paid when they were a younger.
"I remember when a candy bar only cost a nickel."
"I used to buy gas at that station for 15¢ a gallon."
"When did milk get so expensive?" "You paid HOW much
for your home?"
Inflation in America has been relatively steady. There
have been some periods of high inflation, such as
was seen in the 70's, but on average inflation in
the US has been steady at about 3% for the past 30
years. Some countries have experienced inflation above
1000% in a single year.
The 3% figure is also pretty close to the average
as you go further back in US history. So we will use
the 3% figure as we discuss the effects of inflation.
A detailed analysis of the cause of inflation is beyond
the scope of this short article, but we can mention
some things that tend to cause inflation.
Increases in government taxes and fees can lead to
inflation (especially when businesses are taxed).
When the cost of business goes up, product prices
go up. When prices go up your income effectively goes
down. Then you have to work harder or find a better
job. Or hope that your employer will give you a raise.
Which then makes the business costs go up and so prices
go up and so on.
Also when your personal income taxes, property taxes,
sales taxes, auto registration fees, etc. increase
you are forced to live on less or hit the boss up
for a raise.
If you get your raise (and several of your co-workers
also are given raises) the cost of doing business
has gone up. The business will then pass the extra
costs on to their customers - inflation.
Inflation can also be caused by scarcity. If there
are only a 10,000 Beanie-Babies, "Tickle-Me-Elmos",
"Chicken-Dance-Elmos", or what ever the current toy-craze
is, and there are 100,000 people that want one, the
price is going to go up.
If mad-cow disease causes cattle ranchers to destroy
large portions of their herds and there is less beef
on the market, the price of beef will go up.
If interest rates go up, inflation can also result.
If it costs more to borrow money, the cost of doing
business has gone up and so will product and service
For the last 10 years inflation has been relatively
low. It is my uneducated opinion that inflation has
been minimal because people have relied on the stock
market boom of the 90s to supply extra cash. Also
many people have taken on additional debt rather than
curtail their spending.
But people can only stand so much debt. Once you are
maxed out on your ability to pay (you may never max
out your credit limit as long as you keep paying on
time), you will either have to reduce your lifestyle,
beg for a raise or find a higher paying job.
I predict that once the majority of middle-class America
is saturated with debt, inflation will begin to rise
or the economy will stagnate for years until some
of the debt is paid down or people's homes appreciate
so that they can borrow more money against them. (Yes,
you will be getting further into debt, but at least
you can buy that new boat.)
For the most part, regular, steady inflation has little
effect on our day-to-day living. Most people get a
pay raise every year or every other year that either
keeps pace with inflation or helps them move a bit
But when you are looking at the long run and making
long term plans, inflation can have a big impact.
For example if you are 30 right now, wouldn't it be
great to retire with a million dollars when you are
60. You could live on that forever. Right?
Well, let's factor in just 3% inflation for 30 years
and see how much your million will buy then. After
30 years of 3% inflation, one million dollars will
buy about $400,000 worth of goods and services. That's
60% of your money gone to inflation.
If you were counting on a monthly retirement amount
of $2778 each month for 30 years, you now only have
the equivalent of $1111 each month. Less than half!
Could you live on $1111 a month?
Sure you may have your home paid for and you won't
have to buy expensive work clothes or pay for lunch
every day, but your medical bills will go up as you
get older and your insurance costs will increase.
Also you may want to golf or travel more than you
do now. You will have more time for hobbies; how will
you pay for them?
The biggest problem I see with a lot of long range
financial planning, especially retirement planning,
is that people forget to factor in the effect of inflation
on their investments and savings.
You may be able to live on $2778 a month at today's
prices, but could you live on $1111 at what prices
could be 30 years from now.
So what can you do about inflation? Really nothing.
It is out of your hands.
But when planning for the future you can include it
in your calculations. If you want to live on the equivalent
of $2778 a month when you retire 30 years from now,
you need to plan to save/accumulate $1.8 million and
have it invested at 5% after you retire and want it
to last 30 years.
That means that if you are earning 11% (as the stock
market has averaged for the last 30 years) and you
are 30 now, you will have to invest $500 each month
to achieve this goal. If you only invest $100 a month
you will need an average return of 18.4%. (If you
can average that, you should be managing the world's
A good financial planner will understand the effects
of inflation and help you plan for them. But I suspect
that some less-trained "planners" (who are probably
more like salespeople in a financial planner suit)
tend to "forget", ignore or don't understand in the
first place the effects of inflation.
Leaving it out of the plan makes the calculations
easier and may even help them get more "sales" because
you are not discouraged by the truth. And their "product"
(investment) may not seem as inadequate as it may
Another quick way to account for the effect of inflation
is to subtract the inflation rate from any rate of
interest you will be receiving on an investment. So
if you are going to assume a 3% inflation rate and
the assumed rate of return is 11%, do the projection
with only a 8% rate of return or interest.
This will give you a more accurate picture of the
value (not the amount) of the investment at its maturity.
Some investments such as real estate and precious
metals (gold, silver, etc.) actually benefit from
inflation. This may make you want to truly "diversify"
your portfolio into more types of assets, not just
more types of stock.
Inflation does not have to be scary as long as you
understand how it works and how it affects your future
money values. Accounting for it in financial equations
and projections can be done simply. But overlooking
it or downplaying its effects can cause you to miss
your financial goals by a wide margin.
© Simple Joe, Inc.
David Berky is president of Simple
Joe, Inc. a marketing company that sells simple software
under the brand name of Simple Joe. One of Simple
Joe's best selling products is Simple
Joe's Money Tools - a collection of 14 personal finance
and investment calculators. This article may be
freely distributed so long as the copyright, author's
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