Inflation is when you pay
fifteen dollars for the ten-dollar haircut you used to get for five
dollars when you had hair.
Sam Ewing
Here’s a quick question: would you rather buy a
one-year Treasury bond that paid 9.9% in 1980 or one that yielded 7.3%
in 2000? The answer seems obvious – the higher yield is preferable.
Believe it or not, the better investment was the 2000 Treasury bond,
even though the yield was 26% less than in 1980. The difference, of
course, is the rate of inflation that investors were experiencing
during each time period. Prices rose over 12% in 1980, while they
climbed only 3.5% in 2000.
We hear a lot of talk about inflation, and it’s
opposite deflation, from people like Alan Greenspan and "experts" in the
media. But what exactly is inflation? And why does it matter to
investors?
Individuals save some of their income in the present
so that they are able to buy goods and services in the future – things
like travel, an education for their children or food and shelter when
they retire and are no longer earning income.
Inflation (deflation) is the measure of how the prices
of those goods increase (decrease) over time. After inflation those
future goods and services we are saving for will be more expensive -
$100 in January 1980 could only buy $88 worth of "stuff" just 12 months
later. It would buy $42 of "stuff" today. You can see why Former
President Ronald Regan referred to inflation as " … a mugger, as
frightening as an armed robber…."
Most investors would say that the goal of investing is
to grow their investments, but that’s really only half of the battle.
You must grow your money at a rate faster than inflation in order to
succeed. The total return from your investment is called the nominal
return, which tells you how many more dollars you have than
when you started. If you want to know how much "stuff" those invested
dollars could buy, then you need to subtract the effects of inflation.
Reducing the nominal return by the rate of inflation tells you
the true buying power, or real return, your investments have
garnered for you. This real return is the reward for saving
income when you could have spent it.
