You might find it difficult to believe that a single financial phenomenon is responsible for most of our economic activity. This week we’re going to look at the reason money loses value over time and why it makes it really hard to retire.
Inflation is the reason your grandparents get to remind you everything used to be so cheap when they were young. It’s the word to describe prices going up over time.
Prices either rise because people want things faster than they can be made or because it becomes more expensive to make things. For example, if the price of electricity goes up because there’s not enough coal, the price of most products will go up because the producers have to pay more for electricity.
If inflation didn’t exist, the financial world as we know it would be completely different. We would keep the money we’re earning in a bank account and retire comfortably. Thanks to inflation, we have to find a way to increase the value of our cash over time or risk not being able to afford anything we need.
How do we know how much inflation is?
Inflation is an index that indicates how much the prices of overall goods and services go up over time. It’s usually calculated by comparing the prices of goods and services most people use from one year to the next. Bread is an example of a product that’s always in the inflation basket. When we compare the price of bread today to the price of bread last year, we know exactly what bread inflation was. Statistics South Africa compiles the inflation index by deciding which products we need to keep tabs on. It includes food products, housing, clothing, medical care, insurance and education.
While inflation gives us a sense of how much prices rise in the overall economy, our individual inflation might be different than the inflation of the world around us. For example, you might be a vegetarian teetotaller. Your personal inflation could be lower than everyone else’s because you don’t spend money on meat and alcohol.
Inflation is an unstoppable force in the economy, but in our personal finances we can control how much our cost of living goes up every year. It’s critical to keep a close eye on your lifestyle expenses every month.
Inflation is a money-eating monster
If your inflation is exactly the same as that of the overall economy, it means your salary can buy you less every year. Our friend Stealthy Wealth explains how to work out exactly how inflation will affect you in this post.
If your money buys you less every year, cash becomes less valuable as time goes by. This is why it’s critical to save your cash in an account that pays more interest than inflation. Doing this means your cash tomorrow can buy exactly what it could today. However, this is still not enough to build a nest egg.
To build a retirement fund your money not only has to beat inflation, it has to grow too. As we explain in a later post in the series on the difference between saving and investing, investing is a way to put your money to work.
To know whether your money is working hard enough, you have to deduct the fees you’re paying in your investment account as well as inflation. What you have left is what you have to retire on: your real returns
Tip: Deciding what to invest in is tricky. You can get some help here.
How do I defeat the monster?
To get the upper hand on inflation, remain attuned to your personal expenses at all times. When you notice that the price of one beloved product rises more than all the others, it’s time to find a substitute. This is an easy way to keep your personal inflation at a minimum.
Ensure the money you put to work, works hard enough. Money that grows only by inflation is money that’s not working hard enough. To do that, it’s important to know the difference between saving and investing. We discuss this in a later post here.
Being outstanding with your money doesn’t have to be hard. This series of articles will give you all the tools you need to get your house in order to start investing.
This series of articles was sponsored by OUTvest, and written by Just One Lap in 2018. It’s timeless wisdom that needs to be out there – in public spaces where it can feed into ongoing discussions about long term financial wellness. We are republishing this series to make outstanding Fridays (but you’re welcome to read ahead).