Many, many years ago, when my grandmother was still alive, we had a conversation that went something like this:
“I don’t understand it. I watch my pennies, but I seem to be missing something somewhere.”
“What do you mean, Grandma?”
“After I pay my bills, I have what’s left over and its my bowling money.” (Grandma loved to bowl).
“I know you love to bowl, so it’s good you can afford it.”
“Well, that’s just it. I used to be able to bowl three games a week on what was left over, but now I can only afford to bowl two.”
“That’s inflation, Grandma. All the things that you buy are going up in price, but your income (which was only Social Security) stays pretty much the same. So there is less money after the bills to use for bowling.”
“Won’t be long before I won’t be able to afford to bowl at all.”
Up until the last couple of months, we haven’t heard much about inflation. Now, all of a sudden, it is front page news. I think most all of us reading this have a grasp of what inflation is, but many may not have been around during the last real bout of inflation we had back in the late 1970’s and early 1980’s. So I think revisiting the damage inflation can cause is worth doing. Let’s say you have $50,000 in an account at the bank. The bank is paying you 2% interest. (You can’t find anywhere near that today). So in a year you would earn $1,000 in interest. At the end of the year, you have $51,000 in the bank. If inflation was running at 4% that year, the $50,000 you started with in the bank would only purchase $48,000 worth of goods and services at the end of the year. So in terms of purchasing power you have actually lost $1,000. ($48,000 plus $1000 interest).
But it’s actually worse than that! You have to pay income tax on the $1,000 in interest you earn, unless it’s in some type of tax deferred account. If you are in the 15% tax bracket, you pay $150 in federal taxes on your $1,000 of interest, so you only keep $850. Now the purchasing power of your $50,000 at the end of the year is $48,850! In this example, inflation has stolen $1,150 in purchasing power from you. That’s a lot of lines of bowling.
This example shows the obvious. You must keep your assets invested at rates above the inflation rate if you are going to maintain or increase your purchasing power. But how much? The answer to that is something we call “The 4% Solution.”
Let’s take the same example, except this time we invest the $50,000 and achieve an 8% rate of return. Obviously to achieve this, you have to take on additional risk. At 8% your $50,000 earns $4,000 in earnings. Less 15% in taxes, you keep $3,400. With 4% inflation, your original $50,000 loses $2,000 in purchasing power. But at the end of the year now, you actually have $51,400 in purchasing power.
This may all seem kind of trivial when looking at it over a one year time frame. But if inflation averages 4% over a ten year period and you continually invest at a rate that is 2% below inflation, the purchasing power of your $50,000 at the end of that 10 year period is only $41,017. Inflation quietly stole almost $9,000 from you.
The “Silent Thief” is here. Protect yourself.
These are the opinions of Legacy Wealth Management, LLC and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice.
Mike Berry is a Registered Representative offering securities through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Legacy Wealth Management, LLC and Cambridge are not affiliated. Cambridge does not offer tax advice.
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