How to define inflation?
To understand inflation, it’s easiest to assume a basket of goods (e.g. cars, TVs, fuel, and groceries) and services (e.g. barber, cinema, and driving by train). Inflation itself is a quantitative measure which is defined as the rate at which the average price level of the above basket increases within a given period of time (predominantly over one year and expressed as a percentage value). Thus, inflation measures the decrease of purchasing power in the domestic currency.
For ease of calculations, assume the average price of last year’s basket to be $100, while this year’s average amounts to $102. The 1-year inflation rate is then $102/$100 – 1 = 0.02 = 2%.
The impact of inflation on your wealth
To access how inflation affects your wealth, we will assume three different methods of handling your savings:
- Holding your money in a bank account (almost no risk)
- Investing in 10-year government bonds (low risk)
- Investing in the stock market (e.g. a broad index like the S&P 500, medium risk)
Furthermore we consider an investment horizon of 25 years and an initial wealth of $50,000. With respect to the US inflation rate of the last 20 years (source), annual inflation is assumed to be constant at 2% per year (which is also the target of most central banks). To calculate the real value of our investment in t years, we need to calculate the ratio of compounded returns and the compounded inflation rate. Since returns and inflation rates are assumed to be constant it follows:
Wealth in t years = Wealth in t=0 * (1+return)^t / (1+inflation rate)^t
All conclusions are drawn from conducting the interactive calculator at the bottom of this article.
Holding your money in a bank account
In the recent past, interest on bank accounts strongly decreased. Nowadays, most accounts offer interest rates of slightly above zero (average bank interest rates in 2019). Thus, it seems meaningful to assume zero interest. As a result, the real value of our initial wealth will decrease by roughly 2% per year (as we have to divide by 1+0.02 instead multiplying by 1-0.02, the actual loss is slightly smaller than 2%). The figure below nicely illustrates the effect over time.
After only 5 years, the real value of your wealth is already reduced by more than $4,700 which is equal to a loss of 9.4%. After 11 years, buying power decreases to almost $40,000 (-20%) and in 25 years you will end up with roughly $30,500, tantamount to a loss of almost 40%! Thus, even rather small inflation rates have a strong impact on the real value of your wealth.
Investing in 10-year government bonds
Following the Corona crisis and several bond purchase programs, the return on government bonds also displayed a sharp decrease. In 2020, returns varied from 0.7% to 1.9%, following roughly 2.5% in the previous years (see treasury.gov). Thus, it seems reasonable to assume an annual return of 1.5%. While still losing purchase power, the annual loss reduces to roughly 0.5%.
After 5 years, the purchasing power of our wealth still amounts to almost $48,800 (compared to $45,300 in a bank account) and in 25 years it decreases to roughly $44,200 (-11.6%). Thus, government bonds strongly reduce incurred losses, while risk remains on a low level. However, if you want to increase the real value of your wealth, you need to take into account other investment opportunities.
Investing in index ETFs
Over the last decades, average (annual) stocks returns amount to roughly 7%-10%, depending on the index (with respect to all common stocks of the NYSE, AMEX and NASDAQ ~ 9.8%). An easy way to participate is to buy ETFs on indices like the S&P 500 which is broadly diversified and includes the 500 largest stocks of the US market (why ETFs are a good start for your investment career). This way, we can increase annual returns while keeping risk on a moderate level (compared to individual stocks). Although 95% of rolling 10 years periods (in the last 90 years) offered positive returns, you should still consider that there may be multi-annual periods of negative returns. In our example we will a asumme a rather conservative return of 5% per year. As a result, the annual increase of purchaing power will amount to roughly 3% (1.05/1.02-1= 0.0294 = 2.94%).
After five years our portfolio will obtain a purchasing power of roughly $57,800 (compared to $48,800 when investing in 10-year government bonds). After ten and 25 years the real value will increase to $66,800 (+33.6%) and $103,200 (+106.4%), respectively. Thus, stock investments not only preserves the real value of your portfolio but also increases it.
While an annual inflation rate of 2% appears rather small, the multi-annual impact is of great extent. Leaving your money in a bank account (with no interest) over a period of 25 years, results in a loss of purchasing power of almost 40%! To retain the value of your wealth, you should consider investments. First, you could invest in 10-year government bonds. Assuming an annual return of 1.5%, the negative impact of inflation is strongly reduced. However, after 25 years, the real value will still decrease by roughly 11.5%. In contrast, investments in the stock market (assuming an conservative annual return of 5%) offset inflation and even result in an increase of your wealth. After 25 years, you may end up with more than $103,000 – an increase (in real dollars!) of 106%.
However, while roughly 95% of rolling 10-year periods offer positive market returns, there is still a risk of multi-annual drawbacks. To lower the risk of your portfolio, you could buy both stock indices and government bonds. Assuming 80% bonds and 20% stocks, you may end up with an average return of 5% * 20% + 1.5% * 80% = 2.2% which still exceeds the annual inflation.