Simply put, the impact of inflation on investments is that it lowers your returns. This fact has lead me to an investment philosophy that favors high return investments and investments that have inherent value like real estate. It also has me keeping as little money as possible in the bank, because money in the bank is constantly losing value.
If you put keep too much money in low yielding investments or keep too much in the bank, you’ll find the wealth you’ve accumulated stagnating or losing value.
Now let’s see why that is.
How I Think About Inflation
Individuals can have a wide range of goals when investing, and those goals impact how you think about inflation when making decisions.
If you’re like me, then you want the best returns you can get with your money, even if it means putting your own time in. But if it’s important to you to keep your investments as passive as possible, you’ll have a different relationship with inflation.
Inflation is a term used to describe how the prices of commonly bought items change over time. You may have gotten a gallon of milk for $3 last year, but this year it costs $3.25.
I want to list some important points regarding how I think about inflation.
1. Doesn’t affect your money
Inflation has no effect on how much money you make. If your money “doesn’t beat inflation” that doesn’t mean you’re losing money.
I believe it’s important to separate your money from inflation, primarily because…
2. Inflation varies across locations and items
Most places in the world will experience positive inflation every year, meaning $100 will buy less next year than it bought this year. But that doesn’t mean everyone experiences inflation in the same way.
If you spend your entire life in Juneau, Alaska, then you don’t care if the real estate prices in Los Angeles are skyrocketing. It doesn’t affect you. Different cities and different areas of the world will experience inflation at varying rates. So you only care about the inflation seen in areas where you spend money most often.
And to take this even further, you also only care about the types of items you buy. If you ride your bike everywhere, you won’t care much about the inflation on gas prices. If you grow most of the food you eat, then you won’t care much about inflation related to groceries.
3. I try to think of personal inflation
Rather than only using data like “the average annual inflation rate [in the US] is 3.22%,” I prefer to treat inflation as a personal number.
Sure, having those average numbers help predict things far in the future, but they don’t always help us answer the more pressing questions.
If you live in the U.S. and want to quit your full time job, then you probably care a whole lot about the cost of healthcare over the next 5-10 years. Well health insurance inflation rates have seen inflation rates as high as 10% in the last 5 years.
Seems like that 3.22% number may be too low if you’re planning to foot the bill for health insurance for the next 5+ years.
I’ll be assuming a 3% inflation rate for the rest of this article, but I think you should understand that some will experience higher or lower inflation rates based on where they live and what they spend their money on.
Impact Of Inflation On Money In The Bank
Let’s talk about keeping money in the bank. You may be able to get a small interest rate on your money kept in the bank, say 1%. But most money in banks today just sits and doesn’t change.
You put $100 in today and if you don’t touch it for 15 years, you’ll go back and have $100 in your account.
How does inflation relate to this type of money?
Well let’s assume that today we can go to McDonald’s and get a burger for $2.00. Today that $100 in the bank can buy me 50 burgers. But in 15 years of inflation, the burger now costs $3 at McDonald’s. Our $100 in the bank can only buy 33 burgers now.
We didn’t lose any money, but our money buys less. This is why the rich don’t keep much money in banks. They put their money into investments to make sure it gains value over time (or at least retains value), and they keep just enough in the bank to pay bills and buy day to day items.
Keep your net worth in investments, not the bank
Now you should start to see why it’s important to keep the majority of your net worth in investments, not in the bank. Do you think billionaires like Warren Buffet, Bill Gates and Jeff Bezos keep their money in banks? Absolutely not.
I like to keep only about 2-3 months worth of expenses in the bank. Basically, if I spend $1,000 a month to live my life, I don’t want to keep more than $3,000 in the bank. If I do, my money is just losing value.
Everything in excess of my 2-3 months of expenses needs to be put towards investments.
Impact Of Inflation On Investments
Now you’ve probably heard that the stock market averages 10% return on investment each year. This number is like the money we put in the bank. The amount of money we have grows by an average of 10% each year, but inflation causes the actual buying power of our money to grow more slowly than that.
Let’s look at the same example again. This time, instead of putting $100 in the bank, we put it in the stock market. We already know we can buy 50 burgers at $2 each.
If our $100 grows at 10% for 15 years we’d end up with about $400. Without inflation we’d be able to afford 200 burgers ($2 each). But we know after 15 years those burgers cost $3 each.
That allows us to buy 133 burgers. Still much better than the 50 burgers we could have bought 15 years ago, but slowed down by inflation.
In fact, the relationship between return on investment and inflation is easy to calculate.
Inflation Adjusted Return = Return – Inflation
Or in other words we subtract the 3% inflation rate from our 10% return in the stock market to get an inflation adjusted return of 7%.
We have 10% more money, but things cost 3% more, so we can actually only afford to buy 7% more.
How inflation affects various investments
I’ve done a series covering the return potential of various types of investments.
- Return potential of business
- Return potential of real estate
- Return potential of mutual funds
- Return potential of precious metals
- Return potential of collectibles
- Return potential of bonds
All these articles take taxes into consideration, but what they don’t do is take inflation into consideration. Inflation adjusted return is always lower that real return.
Here’s how those numbers change when considering inflation:
|Investment type||Real return||Inflation adjusted return|
What I take from this is that higher return investments aren’t nearly as affected by inflation as the lower return investments.
Bonds, with a return of 3% are actually just preserving the value of your money. Their inflation adjusted return goes to zero which means inflation wiped out 100% of your returns.
But business returns go from 30% to 27%, meaning inflation only wiped out 10% of your returns. That’s much easier to digest.
This is one of the reasons I’ve come to an investing strategy that prefers high return investments over the “safer” low return investments.
Real estate and home appreciation
Inflation is one huge reason why I love owning real estate. One of the metrics for calculating inflation is the price of real estate. And in fact the average increase in value of homes over long periods of time is usually the same as the rate of inflation.
Translation: your home maintains it’s value over time.
You might think “that’s no better than bonds,” since investing in bonds also maintains your money’s value over time.
But the power of leverage is the beating heart of the real estate investment engine.
Beating inflation with leverage
If you go spend $100,000 to buy a house that’s worth $100,000 you’re not using the power of leverage.
If you do that, you’re $100,000 in equity will keep pace with inflation because the value of the home will keep pace with inflation. All your returns on that investment will be from the money you make from renting the place out.
But let’s say you spend $20,000 to buy a house that’s worth $100,000. Conventional wisdom (the wisdom you hear from non-investors) is that it’s bad to take on debt if you don’t have to. But something magical happens when you use leverage to invest.
Your $20,000 still allows you to get the FULL benefits of home appreciation. If the home appreciates by $3,000 next year, you’re $3,000 richer. The guy who put $100,000 into the house is $3,000 too, but you’re $3,000 richer and you only had to spend $20,000 to do it.
Maybe you actually had $100,000, and instead of spending it all on one $100,000 house you decided to spend it to buy five $100,000 houses. Guess what your five houses EACH gained $3,000 in value. So you’re $15,000 richer while the guy who decided not to take on the debt is only $3,000 richer.
“But you have five mortgages” you say. You’re right, and those mortgages will lower our cash flow on any individual property, but multiplying that lower cash flow by five properties actually puts us ahead of our un-leveraged compatriot.
If you want additional context and details around this concept check out the return potential for real estate article.
Factoring In “Risk
Since “risk” is a term thrown around a lot in the media, I want to give my thoughts.
Often you’ll hear investments like bonds labeled as “safe,” and investments like real estate labeled as “risky.” I take issue with those labels.
Every investment has inherent risk. Bonds are not immune to losses. A bond is simply a loan you give to a company or government. You getting your returns is dependent on the ability of that company or government to repay the loan you gave them.
Guess what else? Bonds have a risk specifically called “inflation risk.” You may purchase a bond today at 3% interest while inflation is expected to be 3%. Then in 6 months inflation rates rise to 10% or 15%, this causes new bonds to become available with 10% or 15% interest rates and the 3% bond you’re stuck with is losing value fast.
I like to consider each individual investment as having it’s own unique risks. Investors like us should carefully consider those risks before we decide where to put our money. In my opinion the biggest risk of any investment is ignorance on the part of the investor.
Understand your risks and have a plan in place if the investment starts to turn bad. If you’re just putting your money into something because CNN told you it was a “safe” investment, you have no idea what might happen to your money.
I think I could write all day about my disgust with the popular beliefs about risk in investing, but for this article it’s sufficient only to say that inflation presents a unique risk to those investments (like bonds) which are often labeled as “safe.”
Now we’ve seen why I favor high yielding investments, and why I keep as little money as possible in the bank.
- Money kept in the bank is always losing value because of the effects of inflation
- Money in low return investments, like bonds, will prevent your money from losing value, but they won’t make you richer
- The higher your returns on investment, the smaller the effect of inflation (30% returns only have 10% of their returns negated by inflated while 3% returns have 100% of their returns negated)
- Investments like real estate naturally keep pace with inflation and allow investors to leverage their money to beat inflation consistently
When investing, particularly in your “safer” options like bonds, you should be aware how inflation can turn returns into nothing, or even losses.
I try to be aware of my risks, but tend not to think about investments as “risky or safe.” Since I consider every investment to have inherent risk, I prefer to base my investment decisions primarily on returns and time investment.
My opinion? Take your investments seriously (including your 401k). Don’t listen to the popular media opinion on risk. Spend time to understand where you’re money is going, what your biggest risks are (with inflation in mind), and have a plan in place for if your investment goes bad.