Have you ever saved up for something, only to find that it was more expensive 3 to 5 years later? Many people find themselves in sticker shock when they return to a car dealership 5 to 10 years later and see the new prices. At least some, if not all of that increase has to do with something economists call inflation. You may simply say that it’s more expensive today than it was in the past. Let’s given you a more tangible example using something known as the rule of 72. The rule of 72 is a quick way to figure out how long it takes something to double in price. I will use this rule to examine the college goal of one of my clients.
This client wanted to send their child to a private college where the price at the time we started talking about their child’s college costs was $25,000. It’s now 12 years later. While it was hard to fathom, the average rate of inflation was a bit over 6%. That inflation rate actually continues today. Using our rule of 72 we divide 6 into 72 and see that in 12 years the price has doubled. That was the forecast then and that is the reality today. It’s natural for some people who may have a lump sum of money to want to invest it in something that appears safe. If you get a 1% return on your money and the rate of inflation is 6% you have a gap of 5%. However, the gap is not just simply a 5% gap because of compounding. The 6% inflation is compounding at a faster rate than the 1% compounding is. If we divided 1 into 72, it would take 72 years for our money to double.
In the presence of taxes and fees
If you just want to make sure that the principle you have, gains at the same rate, then you need to get a 6% return after taxes and fees. In the best case, the gains on the principle would be taxed at 0%, but that would mean that you make less than $10,000 in income. If you are a middle income earner, you would pay long term capital gains taxes of 10%. That rates climbs to 20% for the highest income earners. That means for every dollar earned, you would have 20% taken off for taxes. We still haven’t addressed advisory fees, as well as any trading and brokerage fees. Suffice it to say that is a tall order to leap over these costs on a consistent basis.
How do you want to deal with inflation?
Depending upon circumstances, you may be able to deal with inflation in a couple of ways. The first option is to determine the appropriate rate of inflation for each long-term goal that you’re saving for. Things like healthcare, college education and post-retirement living tend to have different rates of inflation. A 2% inflation rate is a much different hurdle than one of 6%. Next, should you save more money in order to jump over these hurdles? Saving more money may not even look like an option. I However are you taking advantage of benefits such as a flexible savings account for your dependents and/or your health care? Can you decrease your cost of credit? Can you buy a less expensive car the next time around? If you get a raise, should you put that towards your new goal? Finally, you may need to to bump up your exposure to market risk. While that may seem uncomfortable, increasing your investment education, may ease that discomfort.
Inflation is just one of the many issues that you need to take into account when planning for the long run. How you should plan for it depends on your facts and circumstances. Don’t let inflation wreck your plans. Let’s get started combating inflation today.