Adjusting for Inflation

Edited Photo. Source: Flickr - Kate Brady

6% or...? On The Rich Moose, I have talked, and will be talking a lot more about Inflation Adjustment. After getting some feedback from you, I am going to explain inflation and inflation adjusting in more detail as it's an important concept to understand.

Inflation

Over time we know the price of goods and services goes up. In Canada, a relatively stable well-run country by international standards, the cost of things doubles roughly every 30 years. A bunch of things that cost $100 thirty years ago costs about $200 today.

That's because the Bank of Canada (our central bank, not RBC) has decided a long time ago to focus their monetary policy on inflation control.

Smart academics have decided that an inflation rate of 2-3% a year is ideal to promote growth and spending without inducing panic caused by prices going up too fast or going down. If prices go up too fast people have a tendency to hoard stuff that doesn't spoil. Why?

If a can of Cola that costs $1.00 today will be worth $1.20 next month, why not buy all the Cola you can get your greedy little hands on right now?

Deflation

If the prices of stuff goes down people also panic. Just consider the somewhat recent housing crashes in Japan, the USA, Ireland, Greece, Spain, Portugal, and many other countries. What initially started as prices going down a bit because of affordability/financing issues quickly spiralled into a panic where people got rid of their houses as fast as possible. Every month people stayed in their houses meant their net worth was dropping by thousands of dollars.

It's psychologically difficult to hold onto an asset that relentlessly declines in value month after month. Why buy a house now for $400,000 if you can buy it next month for $390,000?

In Japan overall prices have declined or remained stagnant for several decades. It has done significant damage to their economy and government finances as people eventually earn less, become less productive, and spend less money on goods and services.

Good luck asking your boss for a raise when he has to drop his prices every month. Try asking TNL@TB for a 5% downpayment loan to buy a house when the price of houses is going down 5% each year. Price deflation brings economic growth to a halt quickly.

Adjusting Investor Expectations

Because the Bank of Canada focuses their policy effort on keeping inflation in the 2-3% range, we can somewhat safely assume, given current information, the value of a dollar will decrease by 2.5% each year over the long term.

When investing, if we deduct 2.5% off our expected nominal return on investment we get our expected "real return" (or inflation-adjusted return) on investment. That's why I use the 6% return number for the RM Balanced Portfolio even though I believe it will nominally return between 8-9% over the long term (as it historically would have).

When we adjust for inflation in our calculations, we are simply adjusting our numbers to make sure that $100 today will buy the same amount of stuff as $100 down the road. No loss of purchasing power. Adjusting for inflation is a must for long-term planning.