For those who know me or work with me, they know I love analogies. The reason I love analogies is that they can take complex ideas and concepts (especially when it comes to finance and the markets), and make them easier to understand by comparing them to something that may be better understood by the person you are speaking to.
When it comes to inflation the analogy I often use is Carbon Monoxide Gas. Inflation, like carbon monoxide gas, cannot be seen, smelled or tasted, but it can kill you!
What is inflation?
I define inflation 2 ways: the technical definition of inflation is the increase in the prices of goods and services over time. Another way to define it is to go out to lunch at a restaurant and purchase a salad and water. You may be expected to pay $15!
During the last 3 years, the inflation rate has floated around 2%. This means that your money needs to grow by 2% per year just to break even with its “purchasing power.” I find myself often reminding the people I work with, that money, if it is not being spent, is just green paper.
A few years ago, I was working with an 82-year-old widow. During our initial meetings I was gathering information and at the end of one of the meetings she mentioned to me that she had been hiding one “investment” that she had not told me about. She explained that she had $20,000 in cash buried in a Folgers can in an undisclosed location in her back yard. After a smile and a laugh, I asked her if she knew what inflation was? She looked at me funny and I asked her how much a cup of coffee was when she was 20 years old? She shouted, a bit frustrated, “a nickel and now you have to go to one of these Starbucks places and its 5-8 dollars!” She was right, but I asked her to consider digging that can out of the ground in her backyard in 10 years. How much money would you have? She again shouted this time with a giant smile “20,000 dollars!” Indeed, but what if you took that money and went to buy something with it? She again looked at me puzzled. I explained that if she could only buy $15,000 dollars of stuff, the reality is that money lost $5,000 of its value over that 10 years it had been buried.
The fact is risk is everywhere. Even in the savings account at your local bank. This is not a commercial for investing, as it is important to have your money diversified with a portion in principal protected vehicles like bank accounts or CD’s, but you must be aware of the risks that exist because they exist in everything. In this case, the risk is hard for people to fully appreciate. A slow deterioration of the value of your money does not feel as painful as the loss you experienced when you took your investments in 2008, which, in a way, makes it more dangerous risk. It can sneak up on people in the worst of times, like when they retire.
For me, one of the foundations of finance is managing risk. To recognize risk exists in everything, and to be able to manage and diversify that risk to take advantage of the upside of different strategies, but to also protect yourself from the downside of the risks by implementing other strategies that will support with its strength the weaknesses of other strategies in your plan.
I often see this balance out of place in individuals that “hoard” money in their bank accounts. Typically leaning too heavily on principal preservation, and in most cases, liquidity (immediate access and control) are reasons that have allowed them to become out of alignment and exposes them to “purchasing power” risk. This can significantly increase the risk of running out of money in retirement.
It is important to be aware of this silent killer. There is no “right number” when it comes to how much money you have in the bank, but it is imperative that you are able to analyze how balanced you are so that you do not run into these issues. Most importantly, you should reduce the erosion of your money over time. There are several aspects that are out to make this reduction to your money: inflation, taxes, market losses and more.
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Written by: Ronnie Thompson