We have some bad news: your money is going off. It’s like milk left out on the bench. It has a use-by date, and eventually, it’s going to go bad and start to smell.
Okay, maybe not quite so dramatic as that. But a version of that story is true. Ever heard the saying ‘a dollar today is worth more than a dollar tomorrow’? Every day that goes by, your money gets a bit less valuable. Not physically, of course—if you put $100 in a safe, then wait a year, that same $100 will be there when you open it up again.
But something does change—the things that money can buy. While your $100 was in the safe, all the stuff you can spend that money on got a little bit more expensive. That means you get a bit less bang for your buck. This is called inflation, and it’s a really important thing to consider when you’re investing.
There are a whole bunch of reasons for inflation, each one more complicated than the one before. So we won’t get into those too deeply today (but if you want to learn more, the Reserve Bank has some great resources explaining the hows and whys of inflation). All we really need to know is that inflation is the constant increase in the price of the things you might want to buy—which means that it’s also a constant decrease in how powerful your dollar is.
You can see this in action by taking a little trip down memory lane. How much did lollies, or a can of fizz, or an ice cream cost at the dairy when you were a kid? Probably not much, compared to today! That’s inflation in action.
What do you do?
There are only two ways to fight inflation: by spending your money, and turning it into something useful, like rent, groceries or petrol (or lollies), or by investing it, putting it to work for you, and getting a return that beats inflation. Otherwise, it slowly but surely fades away.
Inflation tends to average around 2% a year. That means every year, prices go up by around 2%, and your money becomes 2% less valuable. The things that cost a dollar a year ago cost $1.02 now. And like all percentages, it compounds—so inflation adds up faster than you’d think.
This might change the way you think about investing. Lots of low-risk bank accounts pay interest rates of between 1 and 3 percent. On the face of it, this might seem okay—3% isn’t very high, but on the other hand, it’s very low risk.
But you need to subtract inflation from your returns to get your real (inflation adjusted) returns. If inflation is 2%, and you make a 3% return, then your actual returns are a measly 1%. Yikes. And if you make a 1% return with 2% inflation, you’re actually going backwards by 1%. It looks like you gained money, but you actually lost money. Darn.
Beating inflation by playing the long game
If you have a long time horizon, you can both beat inflation and make a great return by investing in higher risk growth assets, like shares. There’s a couple reasons for this.
One reason is that over a long time horizon, shares tend to grow, on average. They may be up and down year-to-year, but your average return usually looks pretty good. So even when you take inflation away, you’re still walking away with a pretty solid return.
The other reason is that inflation is about money you spend now. If a can of fizz is more expensive now than it was a year ago, that only affects you if you’re buying a can of fizz. So any money you have invested for the long term is essentially “protected” from inflation until you sell.
This means that inflation is a great motivation to stay strong if things go down. Let’s say you’ve had some money invested for a year, and it loses 2% of its value and inflation is 2%. If you sell, you’re actually locking in a 4% loss. That’s twice as much as it looks like you lost! But if you hang in there, you can hide from inflation until your returns turn things around. If you end up with a 7% average return per year, and inflation was an average of 2%, you’re still getting 5%. That’s really solid, especially if it’s been compounding over time.
So inflation is a great reason to get on the investing roller coaster, and stay there. Since inflation tends to be on the low side, and long-term returns on shares tend to be on the higher side, the longer you stay invested, the more you’ll beat inflation. And that’s on top of the great returns you’re getting anyway! We think that’s pretty cool.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written.