Friday, October 24, 2008

Inflation: the Savings Killer

What a time to be writing a personal finance blog! I can't recall a time when there have been so few attractive investment options. As virtually everybody has heard by now, traditional investment vehicles such as stocks, bonds, real estate and commodities are all in very bad shape lately. Most of the people with money these days seem to be mainly concerned with safely hoarding whatever they have left, opting for ultra safe, low interest cash equivalents like U.S. Treasury bills.

But stuffing mattresses is really never a good investment plan. This discussion will get slightly technical, but it's important that you understand the concept. The problem with hoarding cash is inflation. Inflation is the investor's enemy, slowly but surely eroding the value of your hard-earned savings. I can remember when I started playing bass in the mid-80's, a set of bass strings cost $10 at the local music store. Nowadays, the same set of strings runs around $18. That's almost double what it used to be, but to tell the truth, I hardly noticed as the price incrementally edged up over the years. In the same way, a nest egg of X thousand dollars, which might seem impressive by today's standards, will surely go less far ten or twenty years from now.

In the United States, most economists consider a "normal" rate of inflation to be somewhere in the neighborhood of 2-4% annually, and the government manipulates interest rates and other monetary policy tools to try keeping it around that level. Actual inflation rates, however, can vary considerably. If I assume that the government will be effective in maintaining inflation at, say, a 3% level over my lifetime, then I must earn consistently at least 3% on my investments just to prevent my savings from eroding. And if I eventually plan to live off of those savings, I will need to earn even more.

The problem with cash equivalent investments is that interest rates often barely keep up, or actually fail to keep up with inflation. My money market account is currently paying only 2%. The way things are going, it doesn't look likely that interest rates will be going up significantly any time soon, but even under the best of circumstances, cash equivalent investments rarely exceed inflation by very much.

Historically, investments such as stocks and bonds, although they involve more risk than cash, tend to outpace inflation by sufficient margins to actually grow your nest egg over time. It is certainly scary to invest in such things at times like this, but the prospect of eventually retiring with a severely stunted cash nest egg is even scarier to me. I suggest taking another look at my previous blog entry on the related subject of compound interest. Then try playing around with some numbers using these online inflation and compound interest calculators.

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