How Inflation Affects Your Savings

What is Inflation?

The money you have today is most likely going to be worth less than that same amount of money tomorrow.  That is why saving for retirement is not just about squirreling money into a savings account, it’s about investing.

Have you recently gone into the grocery store to buy a can of soda and thought “Man, soda’s more expensive than I remember when I was a kid.”  If you have you have just noticed inflation.
The average rate of inflation is about 2% per year.  That means that 1 dollar this year will be worth .98 cents next year.  Similarly 100 dollar this year will be worth $81.71 in 10 years.  Here’s a chart for how the value of money decreases over time:

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As you can see, in 40 years the value of your money will almost half.  A savings account will generate some interest, but usually less than a percentage point.  In order to combat inflation, your money needs to grow more than 2% a year.

Why do we have inflation?

This is a highly debated topic for economists.  The current prevailing opinion is in support of inflation targeting.  Inflation targeting is the idea that economies do better under slight inflationary circumstances.  The argument states that inflation causes people to see increases in their salary (although they might not notice the raising costs) and also stimulates the economy by encouraging people to use their money instead of letting it sit in a bank account where it will lose value.

The Federal Reserve has a target rate of inflation of about 2% annually.  This is considered small enough to decrease volatility in the economy that come from high inflation and large enough to effect decision making in the general public.

How Do I Prevent Inflation From Affecting My Retirement?

In  order to stop inflation from chipping away at your retirement savings, you need to make sure your retirement money is earning interest at a rate greater than 2% a year.  Investing in the stock market is the most common way people grow their money; although, you do have to be careful with how you invest it.

Exchange Traded Fund (ETF)

Exchange Traded Funds are pools of investments that match the stock market.  ETF’s are not managed daily meaning you don’t have to pay the same fees as you would for a mutual fund.  ETF’s are a great tool for long term investment, because the low fees mean a smaller marginal cost which over time can save you loads of money.  For beating inflation, ETF’s historically average 10% returns per year, although that is a long term percentage.

Mutual Funds

Mutual Funds are very similar to ETF’s in that buying a mutual fund gives you access to many stocks at once.  Mutual funds, however, are usually run by hedge funds that try to beat the market.  Because they are providing a service by trying to get greater returns than the market, there is a larger fee for a mutual fund than an ETF.  Mutual Funds can also be a great addition to a portfolio.  Mutual funds also make about 10% a year.

Individual Stocks

Buying individual stocks CAN give you amazing returns on your investment, or you could lose it all.  Although this all or nothing mentality can seem attractive to some, it’s not a guaranteed way to stay above inflation.  If you really support a company and it’s product then go ahead and invest a small portion of your portfolio, but I wouldn’t bank on every stock beating inflation in the long or short run.

Why I’m starting my IRA at 20.

 

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About 3 weeks ago I started my first retirement account.  To many in their 20’s, starting a retirement account seems senseless because they have little expendable income, loans, and are a long way off from retirement.  But money you put away today will go a long way in the future.  When you calculate the good money habits you’ll develop and compounding interest, starting early is the key to retirement.