by Ever wonder why everything seems to get more expensive, whether it be food, transportation, or housing? The answer, most simply, is because of inflation. This post explains what inflation is, how it works, and most importantly, how to beat inflation.
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Effects of Inflation
“Back in my day… soda used to cost a nickel.” -Stereotypical Old Man
Why do old people always talk about how cheap things were?
However, don’t be fooled about “cheap” prices.
Even though a nickel sounds “cheap”, a nickel 60 years ago had a lot more VALUE than a nickel does today.
Just check out the cost of living in 1958:
Can you imagine buying a house today for less than $12,000?! How about a brand new car for $2000? Oh but if you were making the average salary, you’d only be making $4650 a year! Ouch!
But $2000 in 1958 had a lot more value than $2000 does in 2020. That is because inflation increases the prices of items in nominal terms.
Inflation Rates
Inflation make things more cost more money in nominal terms. What have been the historical inflation rates?
Here’s the annual rate of inflation in the United States as measured by the Consumer Price Index back to 1914 according to Macrotrends.
There were a few moments of deflation, particularly in the 1920s and 1930s; however, for most of the last century in the U.S, there has been inflation.
Even though there were a few moments of double digit (10%+) inflation, inflation has hovered around 3% over the past 30 years.
How is Inflation Calculated
Inflation is measured through the consumer price index (CPI) by the U.S. Bureau of Labor Statistics.
It takes a weighted basket of items like food energy, shelter, and transportation, and compares the prices month to month and/or year to year.
As you can see from the chart, From March 2020 to April 2020, the cost of Food increased by 1.5%, the cost of gasoline dropped by 20%, and the price of clothes dropped by 4.7%. Are you surprised? I’m not. My thinking is that this was around the time when cities started to shut down and businesses implemented their work from home models. As less people were commuting to work, the demand for gasoline plummeted, resulting in the 20% precipitous drop. As people no longer had to buy clothes for work or hanging out, the cost of clothes dropped as well.
Based on the Bureau’s weighting system, you can see that 1 year inflation (from September 2019 to September 2020) was 1.4%.
That means that if you had a basket of goods which included a little bit of everything and paid $100 in September 2019, you would have to pay $101.40 for the same basket of goods in September 2020 since the price increased by 1.4% over a period of one year.
Inflation Comparison
Let’s take a look at 1975 cost of living compared to 2015.
People back in the day were so poor right? For minimum wage, they were only making $2.10 an hour in 1975! Minimum wage work provides $8.25 an hour in 2015, so they’re four times richer right?!
Not so fast. Inflation here to cause confusion again.
A dollar in 1975 was worth a lot more than a dollar was worth in 2015.
So much more in fact, that $2.10 an hour in 1975 would be equivalent to $9.16 an hour in 2015 dollars. Technically, you were making MORE money (less nominal money, but more valuable money) in 1975.
Lots of the big purchases were a lot cheaper in 1975 if you compare 2015 cost to the 1975 cost in 2015 dollars. A new house was cheaper, a new car was cheaper, even college tuition was cheaper.
Was the standard of living much better in 1975 then? Not necessarily.
In some categories, you’re comparing apples to oranges.
If you see in the footnote, the median home in 1975 was significantly smaller than a median home in 2015.
College tuition seemed a hellava lot cheap back then in 1975. But this is also not an apples to apples comparison.
College was cheaper, but less financial aid was available back then. Financial aid continues to increase as shown below.
Paul Tough from New York Times Magazine mentions that:
“At private, nonprofit four-year colleges — a category that includes most of the nation’s highly selective institutions — 89 percent of students receive some form of financial aid, meaning that almost no one is paying full price.”
Furthermore, “The average student at private liberal arts institutions paid 50% of the sticker price in 2018.”
Source: Business Insider
Why Inflation Happens
“Inflation is taxation without representation.” – Unknown
If your money loses 3% in value due to inflation, you can almost think of it like a tax. Every year you’ll be paying that tax. It is a tax, paid by everybody holding the currency, that is not required by any legislation.
“Inflation is always and everywhere a monetary phenomenon…” – Milton Friedman
Inflation is determined by supply and demand. The federal reserve manages the money supply and targets an annual inflation rate of about 2%.
Why 2%?
The fed wants to maximize employment and price stability.
Too high of an inflation may make it difficult for people to purchase essential items like housing, transportation, and food.
Too low of an inflation may make it harder to cut interest rates if the economy needed a boost.
Source: Federal Reserve
Why you need to Beat Inflation
You need to beat inflation, or at the very least KEEP UP with inflation, if you don’t want to lose money.
Let’s say you wanted to buy a selection of chocolates for $100 in 1975. You missed your chance to buy it, so you put the $100 bill under your mattress to keep it safe.
It’s 2020 and your sweet tooth has returned. You pull out the $100 bill from under your mattress and run to the local sweet shop.
You feel a sense of sticker shock when you see the price! If the price of chocolate closely matched the rate of inflation, the current price of the same chocolate would now be $483.79!
Your $100 can barely even pay for a quarter of the chocolate.
If instead you purchased $100 worth of treasury bonds in 1975, you would likely have enough money to cover the $483.79 in chocolate. That’s if the treasury bonds KEPT UP with inflation.
How to Beat Inflation
Why stop at keeping up with inflation? Why not try to BEAT inflation?
One thing that has done a great job at beating inflation is the stock market.
Based on history, the average S&P 500 annual return is 10-11% from 1926 to 2018 according to Investopedia.
If you invest the $100 in an S&P 500 index fund in 1975, you’d have over $10,000 by 2020.
That’s some legit chocolate money right there. You could buy chocolate for your friends, your family, even start a chocolate slush fund for your kids.
Some respectable index funds include Schwab’s SWPPX and Vanguard’s VFIAX.
Putting It All Together
Inflation, if left unmitigated to rampage your portfolio, will erode the value of your money over time. One way to protect yourself from inflation is to invest your money, whether it be in stocks, bonds, real estate, etc. If you invest in an S&P 500 index fund that returns 10% a year, and the inflation rate is 3% a year, then you’ve effectively beaten inflation and increased the value of your money by 7%. This is one surefire way to get closer to financial freedom!
