You hear a lot about inflation (rising prices) and deflation (decreasing prices) these days. Most people feel we are currently in a period of deflation, but worry that the huge stimulus plan and associated funds from the government will force the country into a period of very high inflation. What does this mean to you and how will it affect your investment strategy?

What is inflation?
In general, when prices of most things in the economy continue to rise over time, that is considered inflation (read what Wikipedia says about inflation). What this means over time is that the value of a single dollar will buy less now than it did at some time in the past. Small to moderate Inflation is usually good for an economy since companies usually pay higher wages (give employees raises periodically) which means more money to spend. Other people who are self employed can make more money every year by raising prices. As long as income continues to rise as inflation rises, then the economy is able to expand and people are still able to buy the things they need and want.

However, when inflation rises too fast, then wages/income may not be able to keep up. In that situation, people are not able to keep up with buying the same things they used to. The standard of living goes down and the economy gets out of balance. Something has to give. Usually the government steps in and raises interest rates to take money out of the economy in an attempt to bring high inflation down to the small to moderate level desired.

What does inflation mean to you?
Simply, it means that you can’t buy as much today as you could years ago with the same dollar. In my own case, I can remember as a kid paying 10c for a candy bar and paying 45c for a movie ticket. When candy went to 25c, I thought that was crazy and had a hard time paying that much in my mind. Now candy bars are well over $1 and movie tickets are around $10! I went from being able to go to the movie and get five candy bars (not that I EVER would have done such a terrible thing as a little sweet tooth boy…ha) to today spending nearly $20 total for those things. You also know stories of how your parents paid some ridiculously low price of say $10,000 for their house and you are paying hundreds of thousands of dollars for a similar home. Gold used to be less than $50 an ounce in the early 70s and now is nearly $1,000 per ounce. I could go on and on, but you get the point.

Look at what inflation does over time to the dollar
Lets look at how inflation devalues the dollar over time. In the table below, you can look at different rates of inflation and what a $1,000 today will be worth at each 5 year period going into the future.

Year 2% 4% 8% 16%
00 1,000 1,000 1,000 1,000
05 905 818 669 447
10 819 670 448 200
15 741 548 300 89
20 670 449 201 40
25 606 367 134 18
30 549 301 90 8
35 496 246 60 4
40 449 201 40 2

Understanding the numbers
In the previous four part series I just completed on understanding compounding interest, I purposely chose interest rates of 2, 4, 8, and 16 percent since each is double the rate of the previous number, yet the resulting compounding effect is much more than double those of the lower rate. In this series of articles on inflation, the same is true in the opposite as inflation compounds its effect by devaluing the dollar over time much more than twice the effect of the lower inflation rate. You can see that $1,000 today will be worth only $449 at 2% inflation, $201 at 4%, $40 at 8%, and only $2 at 16%. Just for fun, at 32% $1,000 today will only be worth $0.002, not even a penny. It would take $5,000 today to be worth 1 cent in 40 years!!!! Hopefully we will never have 40 years of high inflation.

Think about countries you do hear about that have had very high rates of inflation. In that situation, you MUST have some equivalent means of increasing your income at the same or higher rate than inflation or there would be no hope of maintaining your standard of living. Also, that assumes everyone and all things increase at the same rate of inflation to keep the economy in balance. That is extremely, if not impossible to do over a long period of time.

You can see that a small increase in inflation (from 2 to 4% or 4 to 8%) can cause significant impact on your future ability to buy anything with the same dollar. In next week’s article, I will show the same thing in a different way by looking at how investing in an asset that increases with inflation can give you the edge needed to help maintain your lifestyle and why sophisticated accredited investors work hard to identify and acquire such assets in their portfolio as part of their long term investment strategy.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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