Does a 10% return on investments mean your purchasing power goes up by 10%?
To understand the power of compounding interest and the effect of investment returns to your bottom line, it's important to understand inflation: the erosion of purchasing power over time.
On The Rich Moose, I have talked, and will be talking a lot more about Inflation Adjustment. All returns over long time periods must be adjusted for inflation so you can meet your financial goals.
What is Inflation?
Inflation (economic): The rate at which general prices for goods and services are rising, and, consequently the purchasing power of a specific currency is declining.
Over time we know the price of goods and services goes up. In Canada, a stable, well-run country by international standards, the cost of things doubles roughly every 30 years. If 30 years ago you could buy a 12-pack of national brand budget beer for $10, today that same 12-pack will probably cost around $20.
That's because the Bank of Canada—the central bank which controls the Canadian dollar—has decided a long time ago to focus their monetary policy on inflation control.
Smart academics (who are probably not as smart as they think) 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. The academics and central bankers believe they can create stability through control of the currency.
If prices go up too fast people have a tendency to hoard stuff that doesn't spoil. Why? Well, 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?
What is Deflation?
Deflation is the opposite of inflation. Instead of prices moving higher, in a deflationary environment prices for goods and services drop. This means the currency in questions gains purchasing power.
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 spiraled 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 the lady at the bank for a home loan with a 5% downpayment when the price of houses is going down 10% each year.
Due to the psychological effects of declining asset prices, price deflation can bring economic growth to a halt quickly.
Adjusting Investor Expectations
As stated above, the Bank of Canada currently focuses their policy effort on keeping inflation in the 2-3% range. With this information, we can somewhat safely assume the value of a Canadian dollar will decrease by 2.5% each year over the long term.
This is not a certainty! Shocks can and do happen, even to large and seemingly stable countries. But for our purposes it's the best we can do with the information we have.
When investing, if we deduct 2.5% off our expected total return on investment we get our expected "real return" (or inflation-adjusted return) on that investment.
That's why I use the 6% return estimation on my assumptions for a more aggressive investment strategy. The total return might actually be closer to 9%, but the impact of inflation will reduce the true return when it comes to how we an actually spend that money.
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.
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