Money isn’t stagnant, it’s always moving. Whether you’re moving it or forces outside of your control are moving it. Money is in motion. One of the ways in which money moves is due to inflation. This is because the price of commodities increases over time and money devalues. The annual increase in prices of goods and services is called inflation.
What you could buy with a $10 bill in 2010, you cannot buy today with the same $10 bill.
The effects on inflation are not limited to the prices of goods and services, inflation affects financial markets causing changes in interest rates, the value of assets, loans, and even affects savings in our bank accounts.
In short, money is more valuable to you today than it will be tomorrow or next year. This is why the “time value of money” is so important and one of the reasons businesses prefer to receive payment immediately and delay payment as long as possible.
Hyperinflation occurs when the prices rise abruptly and rapidly get out of control. Hyper-inflation occurs when there is an imbalance of demand and supply of goods and services and or an increase in money supply (think government stimulus).
Why Does Inflation Happen?
Inflation happens when prices of goods and services are increased because the raw materials get more expensive, workers demand higher pay, low-wage laws change, production costs increase, the money supply is increased, etc. When people demand these services and goods and are willing to pay a higher price, the prices increase causing inflation.
It’s similar to shares of a company. If a company issues 100 shares, you own 20 of them, you have 20% ownership in the company. If the company dilutes its shares and issues 100 more shares and you still own the same 20, then you now only own 10% of the company. Your power was decreased through no fault of your own.
How Inflation Affects Everyone?
When the inflation rate increases, your purchasing power decreases. So, if the inflation rate is 5%, it means that your purchasing power decreased by 5%. Now if you make the same amount of money every year, you will be able to afford only 95% of things with the same amount of money because everything costs 5% more this year.
So, every year, the idle money that is lying in your account erodes as it is hit by inflation just as a sandy shore is eroded by crashing waves. The money you have saved for rainy days won’t buy you tomorrow what it can buy you today.
How Inflation Affects Savings?
Inflation negatively affects our investment if the interest rate at which our investment is growing is not high enough to surpass inflation. If you’re not investing your money, and you have a large cash stockpile in a bank savings account, then you’re essentially committing that money to be a victim of inflation (which isn’t always a bad thing).
Let’s say you deposited $1000 in your bank account at a 1% interest rate and after 1 year, your balance is $1010. What also happened in the same year is an increase in prices and the inflation rate was recorded at 2%. Now, you are behind by $10 this year despite earning 1% interest.
When we hold money in an emergency savings account, we’re earmarking that money to be used in case of an emergency. Because of opportunity cost, we are deciding not to invest that money, but rather hang on to it in case we need it for the short term. This is like an insurance policy you’re creating for yourself. The premium paid for this insurance policy is the rate of inflation and the opportunity cost of the money not being invested.
If the inflation heats up in the coming years while your cash is giving the same low-interest rate every year, they are doing more harm than good. Fortunately, during periods of inflation, interest rates can also go up which might help to mitigate the loss on your balance due to inflation. It all depends on how much inflation we’re talking about.
Inflations Effect on Stocks and Assets
When inflation occurs, each dollar buys less than what it could buy yesterday. Assets tend to increase in price due to the effects of inflation, but it’s not so simple. If interest rates climb, stock prices typically suffer as there are other less-risky alternatives like bonds that now provide a reasonable return. An attractive bond market may lure some investors away from stocks and as a result, stock prices may suffer.
Growth vs Value Stocks During Inflation
Value stocks tend to perform better during high inflation periods and growth stocks tend to perform better during low inflation periods. I’m a believer in the Ben Graham philosophy that there’s really no such thing as value stocks and growth stocks. Those terms are often used to describe where the company is at in its lifecycle (mature often means value, growth often means young), as well as the management effectiveness (ability to reinvest profits at high returns vs paying out profits in the form of dividends).
During inflationary periods, the stock market has been shown to be more volatile meaning higher highs and lower lows. This can be difficult for novice investors to manage and may cause seasoned investors to head for traditional safe-haven assets like bonds, gold, and real estate.
Should you worry about inflation?
Inflation is something to understand and plan for, but not necessarily to worry about. You’re not going to be able to control your investing environment, but you can learn to work with it. Hyperinflation? If we experience hyperinflation, then we have much bigger problems than our stock portfolios.
How to protect savings?
If you’re saving cash, you should understand why and what the opportunity cost is of holding that cash. If it’s in case of emergency, then you should understand the purpose of that money is to be highly accessible in case a financial downturn occurs in your life. The loss of purchasing power you experience is simply a premium to have immediate access to that cash. Think of it as self-insurance.
We do like to keep some cash on hand, but we also treat our Roth IRAs as a backup emergency fund. This is worst-case scenario stuff we’re talking about, but you can access your contributions penalty-free in a Roth IRA. The downside is you’d have to sell assets and in an emergency, you may be selling at a loss in order to free up that cash.
In over 10 years of marriage, we’ve never needed more than a couple thousand in cash at any given time from an emergency. It’s likely that we will never touch our Roth IRA contributions and they’re better served to compound at much higher rates than a stagnant bank account.
Having cash on hand in the form of an emergency fund is important to us, but anything above what we absolutely need gets invested or pays down any debt we may have at the time.