One of the cruel ironies of money is as follows: the less you have the more you need it.
Take two people – Joe & Morty. Both of them have monthly expenses of $2,750 – rent, food, utilities, car payment, gasoline, and various other stuff. Joe has $500 to pay his bills this month. (His employer went bankrupt and isn’t paying anyone, whether those people are employees or creditors.) Morty has $7,000 to pay his bills this month. (He won the 50/50 draw at the hockey game.) Who has a more acute need for more money?
Obviously, Joe needs it more. Joe’s need is more acute because he doesn’t have enough money to pay his bills. Morty has sufficient money to pay his bills this month, so he doesn’t need more.
I bring this up because it’s a fact of life that’s rarely discussed. Let’s face it. The AdMan has no interest in telling you to think about these things. His job is to get you to spend whatever you have in your pocket right now. And he can’t do his job if he’s also whispering to you that it might be a good idea to keep a little something set aside just in case something goes wrong.
And the Creditor will seduce you with the lie that credit is as good as cash. That’s not true. Cash will never charge you interest, penalties or fees. Cash sits there, waiting to be deployed. Once it’s gone, it’g gone and there’s no obligation to repay anyone. Also, cash is its own cushion of comfort. The more of it you have, the more comfortable you are.
So where does inflation come in?
Inflation erodes the purchasing power of your money. That’s a fancy way of saying things get more expensive over time. If $200 buys you 7 bags of groceries today, then that same $200 will buy you 6.8 bags of groceries tomorrow. And with each passing year, that same $200 will buy you fewer and fewer groceries. The reason for this is that the purchasing power is being reduced due to inflation.
The corrosive power of inflation on your hard-earned dollars is the reason why you ought not to keep your retirement funds in a savings account. If the bank is paying you 0.05% annually, and inflation is running at 1.2% per year, then you’re losing money on your savings account.
Here’s the math:
$1,000 in the bank earning 0.05% is $1,000 x 0.0005 = $0.50. (Yes, that’s right. Money in your savings account earned you $0.50 in one year. For the purposes of this example, I’m going to ignore the effect of taxes on that earned interest. However, rest assured that you will be required to pay taxes on interest earned in your savings account.)
The purchasing power of your $1,000 decreased by 1.2% thanks to inflation.
$1,000 x (1- 0.012) = $1,000 x 0.988 = $988
After one year, the purchasing power of your $1,000 has been reduced to $988. Add to that the $0.50 in interest that you earned. Your new purchasing power is now $988.50… this is the reduction in purchasing power after only one year. Imagine what happens after 5 years? 10 years? Longer?
Maintain Your Purchasing Power
The way to stay ahead of inflation is to earn a return on your money that is higher than the inflation rate. (Strictly speaking, the return has to exceed inflation and the impact of taxes. I am not a tax expert so please consult a tax expert to get advice on tax matters.)
When inflation is running at 1.2%, then you need to earn 1.3% to stay ahead of it. The wider the gap between inflation and the rate of return, the better it is for you.
Your results may vary, but the best thing I’ve done to ensure that my money earns a return higher than inflation has been to invest in the stock market via exchange traded funds. I used to invest in mutuals funds, then I learned about index funds and exchange traded funds. For the sake of transparency, my money is invested with Vanguard Canada. I used to invest with iShares (now known as BlackRock), and I would’ve stayed with iShares if their management expense ratios had been as low as Vanguard Canada’s.
The bottom line is this. You need to guard against allowing inflation to erode your money’s purchasing power. You do this by investing your money in ways that ensure your rate of return exceeds the inflation rate.