If you haven’t noticed, I have a bit of an obsession with inflation (evidence here, here, and here). It is my greatest fear as an investor. I found some old one dollar bills from back in 1973. I knew it was time for another lecture on the dangers of inflation. I’m going to explain what Cash: The Loser’s Game means.
Let’s conduct a little thought experiment. Let’s say Johnny and Sally each received a one dollar bill back in 1973. Johnny, being a bit aloof, promptly loses and forgets about his one dollar bill in his closet. Sally, being rather intelligent and shrewd, invests her one dollar bill into an index fund tracking the S&P 500 for the full 41 years. 41 years later, who’s come out ahead?
Johnny is Poor
In the year 2014, poor little Johnny and his one dollar bill is still worth exactly one dollar. But there is a painful catch: not only is it still only worth one dollar after 41 years, it has actually depreciated tremendously in terms of purchasing power.
Poor Johnny could have bought $5.38 worth of goods back in 1973 with that one dollar bill. Today, he can only buy $1 worth of goods. That one dollar bill, sitting in the closet for 41 years saw a 438.03% change in its purchasing power, with inflation eroding purchasing power on average 4.19% annually.
Sally is Rich
Meanwhile, Sally has seen her one dollar grow to $55. Her one dollar in the S&P 500 index fund has grown at an average annual rate of 10.29%. Not only has her money grown astronomically, it was able to outpace the average annual rate of inflation of 4.19% during the period.
After adjusting for inflation, Sally’s investment in the S&P 500 index fund saw a real annual growth rate of 6.1% (10.29% – 4.19%). The inflation adjusted, real purchasing power growth saw her one dollar bill grow to $10; this means that, after accounting for the erosion of inflation over 41 years, her one dollar has really grown to $10.
Yes, it can be a little confusing and a bit of a mind bender, but the most important take away is that Sally saw her money grow. Substantially.
Inflation: High, Medium, Mild
When I was graphing the inflation numbers through the Bank of Canada’s Inflation Calculator, I noticed some interesting trends with inflation over this 41 year time span.
First, allow me to draw your attention to a period of high inflation in Canada:
This is the period our parents and grandparents talk about: the era of high inflation and high interest rates. Isn’t it pretty unreal that the purchasing power of that one dollar bill lost over half of its purchasing power in a 9 year span?
Did you know that the last real estate market correction in Vancouver occurred during this period. Why?
Because many people who were over-leveraged in the real estate market suddenly saw their monthly mortgage payments skyrocket as interest rates rose with the high inflation rates. As mortgages came up for renewal, many people could not afford the monthly payments on the new, higher interest rates they needed to pay, especially if they were leveraged to the max. Many people simply handed the bank the keys to the homes they could no longer afford and walked away.
Now, let’s move onto a period of decelerating inflation:
That’s not too bad, huh? 4.58% inflation sure as hell beats 9.98% inflation. Inflation in the early 1980s to early 1990s started decelerating from the rather insane levels of the 1970s to early 1980s.
And ever since, we’ve been rather blessed with a long stretch of mild inflationary rates:
Just because we’ve enjoyed a rather tame and mild stretch of inflation doesn’t mean that this will always be the case. Inflation can spike anytime. No one expected such high levels of inflation in the 1970s and 1980s, but that didn’t stop inflation from ravaging savings and purchasing power. Serious investors must always remain vigilant and wary of inflation.
The erosion of purchasing power through inflation is terrifying. Terrifying because it occurs so silently and meticulously. Think of what gas cost back 20 years ago. What? Maybe like 50 to 60 cents a litre? What does it cost now? Maybe like $1.40 a litre. There’s inflation for you.
I try to combat inflation through a variety of means:
Is it just me or do you fear inflation as much as I do? How do you combat inflation?