Inflation is one of the most important concepts that a person can learn about when it comes to economics. In a very simplified explanation, the inflation rate is the rate at which all prices in general are rising in a market over a period of time. Thus, when prices increase each dollar can buy less. Therefore, inflation decreases your currency’s purchasing power.
One way of looking at this simplified explanation is through the eyes of an investor. If one were to invest $100,000 for 10 years at an 8% interest rate then you would have amassed around $215,892; however, if inflation ran at a rate of 3%, then you would only have a purchasing power of $160,644 in today’s dollars. Beyond investing to grow one’s wealth, one can also invest to protect purchasing power from inflation.
I have a friend who is a risk averse investor due to the 2008-09 bear market. He only puts his money in bonds. Specifically, he likes to park money in US Treasury Bonds. He has money in 10-year treasury bonds right now. I try to tell him that this is akin to financial suicide (okay that’s a little dramatic). He is not using the treasuries to create synthetic bonds or some form of financing/insurance, so there is absolutely no reason for him to be “investing” in them. The rate on a 10-year treasury at the time of this writing is 1.565%, so if inflation runs above 1.565% then he is actually losing purchasing power! He is paying the United States government to hold his money. The only reason to do this would be if you thought the banking system was about to collapse or some disastrous event was about to occur. Let’s say my friend has $100,000 invested in these 10-year treasury bonds right now, and he leaves the money there for 10 years with a rate of inflation around 3%. After 10 years he will have around $116,857, but in today’s dollars he will only have a purchasing power of $86,953! He lost $13,047 in purchasing power over a decade because he was in bonds. That is irrational in my opinion. A 3% inflation rate is conservative by many estimates too. Had it been a 5% inflation rate, he would only have $71,740 in today’s dollars.
He counters my arguments to him with the idea that he will lose more in the stock market. I admit that it is possible, but the chances are in his favor if he invests in dividend yielding stocks. In dividend yielding stocks you are guaranteed your 3-5% return, and you get dividends on your reinvested dividends! This form of compounding is very powerful. Should there be a stock appreciation you will make even more money. Over a very long period of time, I believe there is a place for stocks in any portfolio. In the short run I agree that bonds are a safe option to preserve capital that you will soon need. My friend is 26 years old though, so he has an incredibly long time horizon.
I am not sure what the historical average inflation rate is, but I would guess it is somewhere around 3-5% in a healthy economy. Inflation is running at very low levels right now in the current economy. I think the last reading of inflation base on the CPI was in between 1.6-1.7%, so anyone in treasury bonds is currently losing purchasing power and has been for several quarters. Inflation affects so much in our economy that it is crucial that everyone understand its simple effects. It affects interest rates, debt, and market dynamics. I will try to write more on it in the future.